April 7, 2016

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Using leverage to magnify performance is an idea that has enticed investors and traders throughout history. The critical question of when to employ leverage and when to reduce risk, though, is not often addressed. We establish that volatility is the enemy of leverage and that streaks in performance tend to be beneficial to using margin. The conditions under which higher returns would be achieved from using leverage, then, are low volatility environments that are more likely to experience consecutive positive returns. We find that Moving Averages are an effective way to identify such environments in a systematic fashion. When the broad U.S. equity market is above its Moving Average, stocks tend to exhibit lower than average volatility going forward, higher daily average performance, and longer streaks of positive returns. When below its Moving Average, the opposite tends to be true, as volatility tends to rise, average daily returns are lower, and streaks in positive returns become less frequent. Armed with this finding, we develop a strategy that employs leverage when the market is above its Moving Average and deleverages (moving to Treasury bills) when the market is below its Moving Average. The strategy shows better absolute and risk-adjusted returns than a comparable buy-and-hold unleveraged strategy as well as a constant leverage strategy. The results are robust to various leverage amounts, Moving Average time periods, and across multiple economic and financial market cycles.