Leverage With Little Risk

I work at the World Financial Center which is located right next to Ground Zero, so effectively I have to navigate a massive construction site every time I need to go in out of the office. Each day as I make my way to and from the subway I follow a circuitous path up and down stairs and around teams of constructions workers and their gargantuan equipment. The noise, the never ending crowds of tourists, the teeming humanity of my fellow Wall Streeters would drive most of my laid back California friends crazy, but I love the hustle and bustle of it all.

One of the buildings I pass by every day is the Marriot Downtown hotel which is located right on the West Side highway. Not near it, but right on it. When guests come out of the entrance they are greeted by the swishing noise of speeding traffic. The other day as I was leaving my office on a relatively quiet midday afternoon, I noticed a line of taxis sandwiched on a pull off lane of the highway awaiting fares from the hotel and I stopped for a moment to observe. There was absolutely no action from the hotel. The cabs sat motionless for minutes as traffic whizzed by.

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If I was driving a cab in New York, I thought to myself, would I be willing to wait for 10-20 minutes to pick up a fare? Absolutely not. The key to making money driving a taxi is to keep the meter running by constantly picking up fares. In New York especially during the middle of the day, you cannot drive more than 10 blocks without finding someone looking to hitch a ride. In fact the completion for cabs amongst passengers in New York can often rival the intensity of traders in the crude oil pits of the New York Mercantile exchange also located in my building complex.

Why are these guys just sitting there? I wondered in frustration. Get on the road, turn that meter over and make some money, I silently urged the taxi drivers as I headed to the subway.

As I ducked underground, the sight of dormant taxi meters made me think about trading and leverage. Often, in trading leverage is viewed strictly as a function of your borrowing capacity. Borrow 10 dollars for every dollar of your equity and you are 10:1 levered. Borrow 20 and you are levered at 20:1 and so on. We are taught to believe that they only way to achieve greater leverage is to borrow more. But that’s wrong. Leverage can also be achieved through inventory turnover. A taxi driver that can flip over 30 rides every day instead of 10 will make more money by the end of the day. A trader who can flip over his positions frequently (assuming he maintains the same success ratio) will get a higher return on his account without the need to borrow more capital.

This week I did something interesting with my scalping account. I lowered the size of my positions, cutting risk to 1% of my account of each trade from 2%, but I increased the frequency of my trading. The net result was a much smoother equity curve. Even at the end of the week, when I went off the rails ignoring my own model and making a number of idiotic impulsive trades, my lower position size kept me out of trouble and I ended the week net even, when under my former trading conditions I would have probably lost 10% of my account. I was annoyed at the lack of discipline, but my account was in much better financial shape because of the change in tactics. By flipping my trades over in smaller size, I was able to match my lever ratio but with considerably less risk. The strategy saved me from my own worst habits and since in trading what matters most is how much money you have in the account rather than how good or bad you feel about your performance I was much better off in the end.