Should you leverage to the max in a long-run bull market?

July 18th, 2010

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Between 1970 and 1980, gold was in a bull market. In 1971, the average price of gold was around US$40. By January 1980, it hit US$850. So, the question is: Surely, it was a good idea to leverage as much as you can in the 1970s (assuming you knew that gold would be in a bull market)? Since gold prices multiplied by 21 times from 1971 to 1980, and if you leverage to the maximum at any time in the 1970s, you will become filthy rich by 1980 right?

Wrong!

If you leveraged say, 10:1 in December 1974, you will be likely to be financially wiped out by August 1976. Between that time, gold prices fell from US$195 to US$103- a correction of 47%. Then from August 1976, gold resumed its up-trend to the high of US$850.

The lesson here is clear. Even in the midst of a long-term bull-market, you can become bankrupt if you are highly leveraged and unlucky.

Next question to ask: What if a lot of people are highly leveraged at the same time, in the same asset class, believing that it is in a long-term bull market? We will turn the answer to this question to our readers.

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  • Pete

    Great point CIJ 🙂

  • I am J

    Leverage can be used both on long and short, so a total financial wipe out can be prevented. I think I have more to discuss if given more details. Ed, I hope u can elaborate more on the answer.

  • Well, if you leverage on the short side, you better be right about the timing of the correction in the context of a bull market. Otherwise, you can be wiped out too.

  • Pete

    Very much agree. Another issue is whether deleveraging is possible in a short time frame. It depends what you are selling, into which market, to whom.

    For instance it would be fairly easy to sell stocks of an ETF, but trickier to sell physically bullion.

    Also it could be trickier to sell gold stocks as negative news could see them plummet in price quite quickly. Trailing stops can aid in this respect, although they are not perfect either.

    If you are very confident of your ability to read markets you could also try some form of hedging to reduce any losses… futures markets? Forex? Short selling other stocks, all that jazz.

    The simple truth of leverage is that it amplifies gains, and amplifies losses (amplifying losses slightly more than the gains due to the interest component and monetary inflation). And the simple truth of investing is that there is always risk to any investment.

  • DavidL

    Interesting question. What if a big percentage of a market is made up of highly leverage players (not using the term investors on purpose). Sounds like we don't have to guess so much as look at what happened when the music stopped and the GFC began. A big, big crash. Everyone will have to sell to cover their losses, and the only people buying are the shorts who want to take their profits. The only thing that can stop a crash like that would be the shorts, as they would be the only ones buying stock to return it to whomever they borrowed it from. However, not sure that naked shorts would need to do that-can't really understand how naked shorting isn't just fraud? Leverage can get ugly very fast and maybe they will put some limits on it….

  • Great answer! 🙂

    And your answer make us chuckle, especially when we read this…

    The only thing that can stop a crash like that would be the shorts, as they would be the only ones buying stock to return it to whomever they borrowed it from.

    In Australia, after the government banned in short-selling in 2008, the Australian stock market made a record plunge of 8%.

  • I am J

    I think professional traders leverage on both long and short at the same time. Also, timing is only a major concern for retail traders, or the mom and pop investors. As long as the financial system is intact, time is always a good friend to high net worth traders.

  • I am J

    The idea that 'leverage is the path to riches' is the biggest fraud perpetrated to the public. The other would be guessing market direction.

  • Yes, in that case, the traders are betting on volatility, not on the direction (up or down) of the market.

    In options trading, this is called a delta-neutral trading. Some delta-neutral positions can be risky though because they hold negative gamma position.

  • Pete

    That type of trading never occurred to me. Thanks! 🙂

  • Ademac

    If a lot of people are highly leveraged at the same time, in the same asset class, and the bubble bursts. Hard down.

    Take a look at the the distater the is Storm financial.