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How Leverage Scales Risk, Return, and Small Spreads

Article Quant Q&A · Author: curious
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Summary

The document asks why traders use leverage if it does not improve a strategy’s risk-to-return ratio. Its answer distinguishes changing a ratio from scaling the amounts represented by that ratio: leverage increases both gains and losses, allowing a trader to take on more risk in pursuit of proportionally greater returns.

Scaling can make small spreads economically usable when the unlevered opportunity is too small relative to the capital deployed. The explanation is conceptual and brief; it gives no numerical example, strategy comparison, or treatment of financing costs, margin constraints, transaction costs, or liquidation risk. Its point is that leverage can increase the absolute size of an opportunity without improving its underlying risk-return tradeoff, and those practical constraints matter when applying the idea.

Key ideas

  • Leverage scales gains and losses and does not, by itself, improve a strategy’s risk-return ratio.
  • Traders may use leverage to take on more risk in exchange for proportionally larger returns.
  • Scaling exposure can make small spreads economically usable.
  • The explanation does not address financing costs, margin limits, or other implementation risks.

Tags

Risk managementPosition sizingExecution
Full text
# Why use leverage when it does not improve the risk/reward ratio?


# Why use leverage when it does not improve the risk/reward ratio?












Leverage will increase gains when things go right but will also increase losses when things go wrong. Mathematically speaking, it does not change the risk/reward ratio (or does it?). Since investing/trading is all about getting a favorable risk/reward ratio, why do traders use leverage?

## Answer by vonjd (score 3, accepted)

https://quant.stackexchange.com/a/9106

It is true that you don't change your risk/return ratio but you can scale the ingredients of this ratio, meaning that you can e.g. scale up the level of risk you are prepare to take to also lever up your returns. Through that mechanism you can make use of very small spreads.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.