How to Use Leverage to Supercharge Your Trading Returns (and Avoid Disaster)
- FinancialWisdom
- Jun 16
- 7 min read
Amplify Returns AND Reduce Risk!
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Video Transcript Below:
Most people believe leverage is dangerous. And they’re right—when it's used at the wrong time. But when used systematically, in the right environments, leverage can dramatically enhance returns while keeping risk under control.
That’s the central insight from Michael Gayed’s award-winning study: Leverage for the Long Run: A Systematic Approach to Managing Risk and Magnifying Returns in Stocks.
And today, we are covering the unbelievable findings from the study that will change your view on leverage. Let’s dive in.
Michael Gayed, a two-time Charles H. Dow Award winner, was the Chief Investment Strategist at Pension Partners, when he co-authored the paper with CHARLIE BILELLO, DIRECTOR OF RESEARCH.
The key idea of this research is simple but powerful: leverage, when used systematically and in the right conditions, can not only boost returns but also reduce risk. The strategy works by applying leverage only when the market is favorable, specifically when the market is above its moving average, and pulling back during unfavorable periods. This combination creates a rotation model that improves both absolute and risk-adjusted returns over time.
While my approach differs from the one outlined in the study, it also focuses on using indicators to identify periods of low volatility and high return potential. I use the 10/20 EMA crossover—an approach I’ve covered in detail in another video—to avoid unfavorable market conditions. This rule helps me stay out during turbulent phases and get aggressive, even apply leverage, when the odds are in my favor.
Over the past three decades, this strategy has produced an average unleveraged return of over 20% per annum, significantly outperforming the S&P 500’s historical average of around 8% per year. Because the system has multiple checks and risk-control measures built in, applying leverage would have further boosted returns with only a modest increase in risk. If you’d like to understand this approach in more detail, check out the link in the description below.
Moving on, let’s begin by understanding why this study by Michael Gayed matters.
In theory, using leverage just amplifies returns and risk linearly. But in reality, that’s not how markets or portfolios behave. Volatility is not static. Asset prices follow trends and go through different volatility regimes. This means that leverage is not always equally effective—or equally dangerous. The goal is to apply it when conditions are stable and remove it when they’re chaotic.
This challenges a long-held academic view: that markets are efficient and prices are random. Under those assumptions, timing leverage shouldn’t matter. But Gayed and Bilello argue otherwise. Their data shows that market conditions, particularly volatility and trend persistence, are critical in determining when leverage is useful or destructive.
Most people view leverage as a short-term tool—useful for day traders or short-term ETF traders. But this paper proves that with a rules-based system, leverage can be used over long time horizons.
However, there’s a catch: volatility destroys leveraged returns through a mathematical phenomenon called the constant leverage trap. This happens when you’re forced to re-leverage daily in volatile markets. After a gain, you're increasing exposure from a higher base. After a loss, you’re decreasing exposure from a lower base. This whipsawing erodes compounding power. So even if the market goes nowhere over a week, a leveraged position can underperform due to this path dependency.
Consider August 2011. Over six highly volatile trading days, the S&P 500 had a cumulative gain of 0.51%. But a 2x leveraged version of the index lost 0.14%, and the 3x version lost over 2%. That’s the constant leverage trap in action.
So when is leverage actually effective?
The answer lies in environments with low volatility and trending performance, where gains come in streaks, not in erratic jumps. These are the conditions where leverage works because compounding becomes your ally, not your enemy.
The challenge is figuring out when these favorable conditions exist.
Enter the moving average.
Rather than using it as a trend-following or entry-timing tool, the authors use it as a volatility filter. Their research, going back to 1928, shows that when the S&P 500 is above its 200-day moving average, forward volatility is significantly lower than when it is below. This finding is robust across multiple moving average lengths—from 10-day to 200-day.
Moreover, when the index is above the moving average, markets are more likely to exhibit positive streaks—several up days in a row, as can be seen in this finding from the study. These streaks enhance compounding when using leverage. When below the average, markets are more erratic and tend to experience sharp down days.
This insight leads to the core idea of the paper: the Leverage Rotation Strategy or LRS.
Here’s how it works.
When the S&P 500 closes above its 200-day moving average, rotate into the index using leverage—1.25x, 2x, or 3x. When the index closes below the moving average, rotate into Treasury bills or cash. That’s it.
The simplicity of this rule makes it practical and adaptable for real-world use.
Now let’s look at the results.
From October 1928 to December 2020, a buy-and-hold investment in the S&P 500 turned $10,000 into roughly $39 million. Using 2x leverage throughout that period, the same investment becomes over $590 million—but with far higher volatility and drawdowns, including a 98% loss at one point. Using 3x leverage grows it to $2.7 billion—but also includes a 99.9% drawdown.
However, when leverage is applied conditionally using the 200-day moving average, the outcomes are strikingly different. The 2x LRS returns $89 billion. The 3x LRS? Over $28 trillion. That’s not just an improvement in absolute return—it’s a massive boost in risk-adjusted performance too.
Sharpe Ratio, which is a measure of risk-adjusted return, and Sortino ratio, which is a measure of downside risk-adjusted return, are significantly higher under the Leverage Rotation Strategy compared to constant leverage or unleveraged buy-and-hold. Maximum drawdowns are lower, and volatility is reduced.
In fact, in all four of the worst bear markets in U.S. history—1929, 1973, 2000, and 2008—the LRS delivered dramatically smaller drawdowns than buy-and-hold. In the Great Depression, the S&P 500 fell 86%. The 3x LRS strategy dropped 49%. That kind of risk reduction allows investors to stay invested and recover faster.
Recovery time is key. After the 1929 crash, it took a buy-and-hold investor until 1946 to break even. But under the LRS, a 2x leveraged investor was back to new highs by 1936, ten years earlier.
This shows how volatility management, enabled by moving averages, makes leverage sustainable.
Now let’s explore some mechanics and implementation.
First, the strategy requires relatively few trades. The 200-day version averages about five rotations per year. That keeps transaction costs low and makes execution manageable, even for retail investors.
Second, the strategy assumes a 1% annual cost for leverage, which is comparable to what many leveraged ETFs charge today.
Speaking of ETFs, modern execution is easier than ever. Products like SSO (2x) and UPRO (3x) can replicate the strategy without needing to manually re-leverage daily. While leveraged ETFs don’t perfectly track the index due to expense drag and slippage, they still approximate the core effect, and Gayed’s paper shows that the results remain strong even with these imperfections.
In addition, the authors highlight that moving averages help avoid tail risk—those rare, extreme down days that wreak havoc on portfolios. As can be seen in this chart, Historically, the worst 1% of trading days occurred predominantly when the market was already below its moving average.
For example, October 19, 1987, and October 28, 1929—the two worst days in market history—both occurred when the S&P 500 was trading below every major moving average. By sitting in cash during these periods, the strategy sidesteps massive drawdowns that a buy-and-hold portfolio suffers.
It’s also important to understand that the moving average isn’t perfect. It can underperform during persistent bull markets. The study showed that a simple 200-day Moving Average strategy, where one buys the S&P 500 above its MA and rotates into Treasury bills below it, underperformed a buy-and-hold approach during powerful historical bull markets, such as those from 1990-1998, 2002-2007, and 2009-2018. But what the strategy fails to achieve in bull markets is more than made up by reduced losses during bad times, which improves long-term survivability and compounding.
Another key takeaway is that the strategy doesn’t rely on optimized parameters. The results are consistent across different moving average lengths—10-day, 50-day, 100-day, and 200-day. The effect is robust across timeframes and market cycles.
This consistency makes the strategy practical and repeatable.
Importantly, this strategy aligns with real human behavior.
Most people cannot hold through a 50% drawdown, let alone a 90% one. Even if they intellectually understand the math of compounding, emotionally, they abandon the strategy. That’s why most retail investors underperform the market—they capitulate during crashes.
By reducing drawdowns and smoothing the ride, the LRS increases the odds that investors will stick with it. And that, more than anything, determines long-term success.
Finally, the strategy disproves a long-standing belief in finance: that higher returns always require higher risk. By combining leverage with volatility filters, the Leverage Rotation Strategy breaks that rule. It shows that smarter exposure, not just bigger exposure, is what really drives outperformance.
This has broader implications.
If volatility can be observed and filtered systematically, then leverage doesn’t have to be feared. It can be a powerful tool, provided it is deployed under the right conditions. Gayed’s paper proves that the right combination of simplicity, timing, and discipline can beat both market efficiency and behavioral pitfalls.
To summarize:
● Leverage itself isn’t the problem—volatility is.
● The constant leverage trap erodes returns in high-volatility environments.
● Moving averages help identify low-volatility regimes with better return streaks.
● Using leverage only when the market is above its moving average significantly improves performance.
● The strategy reduces drawdowns, shortens recovery time, and increases long-term compounding.
● It's simple, rules-based, and adaptable with modern ETFs.
For long-term investors looking to maximize stock returns without taking uncontrolled risks, the Leverage Rotation Strategy offers a compelling and data-backed solution.
Thanks for watching.
For those interested in enhancing their trading knowledge and techniques, resources are available through the links below.
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