Leverage is a Double-Edged Sword

Abstract

We use proprietary data on intraday transactions at a futures brokerage to analyze how implied leverage influences trading performance. Across all investors, leverage is negatively related to performance, due partly to increased trading costs and partly to forced liquidations resulting from margin calls. Defining skill out of sample, we find that relative performance differentials across the unskilled and skilled persist. Unskilled investors' leverage amplifies losses from lottery preferences and the disposition effect. Leverage stimulates liquidity provision by the skilled, and enhances returns. Although regulatory increases in required margins decrease skilled investors' returns, they enhance overall returns, and attenuate return volatility.

Keywords: Leverage, Futures, Margin call, Smart investors, Trading performance

JEL Classification: D03, D81, G02, G12, G23