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Leverage will increase gains when things go right but will also increase losses when things go wrong. Mathematically speaking, it does not change the risk/reward ratio (or does it?). Since investing/trading is all about getting a favorable risk/reward ratio, why do traders use leverage?

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closed as off-topic by chrisaycock Oct 6 '13 at 15:38

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What LTCM did in the beginning, was an arbitrage on bonds' spreads: each such trade would gain them only a little money even if they would invest all the money they had. They were sure though that such trades are profitable. Using leverage they were able to increase their exposure. –  Ilya Oct 6 '13 at 13:20
    
Alright, you've forced me to be uncivil. You have a habit of posting questions across the Stack Exchange network in an attempt to make yourself sound smart. It's not working. This site in particular is intended for people who work in the industry. –  chrisaycock Oct 6 '13 at 15:42
    
The premise of your question is flawed. The ratio of risk/reward is invariant to leverage only when you define reward as arithmetic mean return. But your end-of-period capital is the geometric mean of returns. After you reflect on that for a moment, read up on the kelly criterion and you'll learn that there is in theory an "optimal" level of leverage for any investment with a + expected return. –  paralogical Oct 8 '13 at 7:22

1 Answer 1

It is true that you don't change your risk/return ratio but you can scale the ingredients of this ratio, meaning that you can e.g. scale up the level of risk you are prepare to take to also lever up your returns. Through that mechanism you can make use of very small spreads.

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