Benjamin Graham, as well as his disciple, Warren Buffett, both strenuously warn against speculating, as opposed to investing, and generally define speculating as any kind of purchase of securities involving leverage. I have always wondered how to square this with the modern portfolio theory view that using leverage is simply a way of moving along the risk-reward frontier. On a fundamental level, if you really know that a stock is going up then you are going to get a bigger return on equity if you gear up. Obviously, on average, you do not, but there doesn't seem anything fundamentally malign about using some borrowed capital to spice up your return. Proprietary traders typically have a performance which is measured on an equity-free position: they have to stand a carry cost of their complete position value.
It was not until I started doing some modest trading myself that I gained a slender insight into the problem of gearing. In my view, it's not the gearing that's bad, but the margin calls. Benjamin Graham talked about a bipolar 'Mr Market' who has extreme mood swings but however crazy is feeling is always willing to trade with you, the investor. In Graham's recipe for trading success the key is to wait for Mr Market to get nearly suicidal and then take some shares off his shaking hands. When Mr Market flips and enters his manic phase, and will pay silly money for any old rubbish, sell the shares he sold you earlier back to him at a handsome profit. Sounds as easy as falling off a log, doesn't it?
Of course, it's hard to judge Mr Market's mood exactly in relation to his mood tomorrow or a year or ten from now. What may seem like a deep depression might prove to be a relatively sunny period compared to later. However, one this is certain. If you are forced to sell when the market has tanked there is no way you are going to do anything but lose money. This happens when you get that unpleasant email called a margin call. This means that the equity you've posted with your broker has evaporated and that further falls (or rises) in the value of your positions will result in him being fully exposed to the risk of you going broke. If you can't post further margin he will sell your position. I can absolutely guarantee that if you let him do this he will chose the exact moment when the market bounces right back and you will have lost everything.
So leverage is very dangerous, and there is no way of entirely avoiding the risk, but at the very least some kind protection should be put in place, whether buying options, overcollateralising, getting to a market neutral position or whatever. None of these strategies is perfect, but doing none of them is probably going to end in tears.
