I continuously review my trading methodology and ask myself if there are ways to improve my performance. My models are based on trend trading ETF’s and using leverage at a 2:1 ratio when going long. If my models are robust, the more money I borrow the more I will make. So why not borrow three times my equity instead of two times?
Of course there is a caveat associated with increased borrowing for my models – it results in a larger maximum drawdown. Using leverage at a 2:1 ratio as I have thus far with my new Combined ETF 2X Model, the maximum drawdown based on backtesting and month-end returns is 8.9% which I am comfortable with. A very quick and dirty estimation of the increase in maximum drawdown which would result from increasing the leverage to 3:1 shows that the maximum drawdown would increase by about 30%. Thus with a 3:1 leverage ratio for my Combined ETF Model, the maximum drawdown would probably be around 11.6%. The compound annual growth rate of the model may increase by 40% from 28% to 39%. Is the increased return worth the increased maximum drawdown? This is a subjective question and the answer is dependent on each investor’s risk tolerance. There is also a practical consideration – does the investor have the ability to borrow three times his/her equity?
FJP
PS: I should add that the 8.9% maximum drawdown is based on an optimized backtest and it would therefore be reasonable to assume a higher maximum drawdown at some point in the future.
