by Looking to leverage your money? You’ve come to the right place. This post explains how you can potentially amplify investment returns with leverage, and outlines three different ways to use leverage in your portfolio.
Contents
What is Leverage?
To use leverage is to borrow money to increase your returns.
For example, let’s say you have $1000 to invest. You can use leverage to borrow money, let’s say another $1000. So in total you have $2000 to invest, $1000 of which is yours and $1000 which you borrowed.
If your investment goes up 10%, your combined investment grows from $2000 to $2200. You just made $200 profit from your $1000 investment, i.e. a 20% return. You doubled your profit compared to what you otherwise would have earned if you didn’t use leverage.
However, leverage is a doubled edged sword.
If your investment goes down 10%, your combined investment shrinks from $2000 to $1800. You lost $200 (or 20%) of your own money with leverage, vs. 10% without leverage.
So even though leverage can increase your returns, it can also increase your losses.
Should You Use Leverage?
Ian Ayres, Barry Nalebuff, professors at Yale, in their book “Lifecycle Investing” advises the using n more than 2x leverage.
They claim that it’s odd in this society that we feel comfortable using 5x leverage when purchasing a home (when people pay a 20% down payment), but people don’t use leverage when investing in the stock market. Of course, they don’t advise 5X leverage with stocks, just UP TO 2X. That would be equivalent to buying property with 50% down.
Leverage is something you should use only if you have the risk tolerance for it and you know what you’re doing.
How to Use Leverage
There are several ways to leverage money: The three most common that I’ll explain here include margin trading, options trading, and leveraged funds.
Margin Trading
You can use leverage money through margin trading. As outlined in the earlier example, margin trading is about borrowing money to invest more. If borrowing 100%, i.e., employing 2X leverage, your investment could increase 20% when your investment would have increased 10% without leverage; conversely your investment could decrease 20% when your investment would have decreased 10%.
Margin trading, however, does come at a cost. Borrowing money is not free. Like with most loans, you’ll have to pay interest. Brokerages charge margin interest if you were to borrow their money on margin.
As of this writing, Schwab charges an effective rate of between 6.575% and 8.325% for margin loans.
Let’s say you borrow $50,000 at a 6.875% effective rate. That means that after one year, you’d have paid Schwab $3437.5 in fees. As they say, it takes money to make money…
Fidelity charges an effective rate of between 4% and 8.325% for margin loans.
Schwab and Fidelity are some of the big name brokerages out there. A lesser known option is Interactive Brokers.
According to its website, Interactive Brokers charges an interest rate of 2.59% for accounts trading with U.S dollars. Its interest rates go as low as 0.75% for their PRO accounts.
Maintenance Requirement
Margin trading not only has the potential to amplify losses and costs you money to borrow. But there is another downside risk to margin trading you should know about.
Brokerages will typically set a maintenance requirement on your margin account. 25% – 30% is the typical maintenance requirement.
Let’s say you have $10,000, and you borrow another $10,000 using your margin account, to trade a total of $20,000 worth of stock.
If the value of the stock drops by 20%, then the value of your equity may fall below the 30% maintenance threshold. In this case, you’ll have to sell stock or deposit more money to meet the margin call. If fail to do so within just a few trading days, the brokerage may sell some of your stock to meet the margin call.
Options
Another way to utilize leverage is through the use of options.
Purchasing an option gives you the right to buy (call option) or sell (put option) a security at a later date.
Example (Call Option):
Let’s look at an example call option for Microsoft:
Call option price: $21.39
Strike price: $200
Expiration date: November 20
To purchase this call option, you would pay $2139 (an option is purchased in increments of 100). In return, you’d have the option to purchase 100 shares of Microsoft for $200 each at the expiration date of November 20. The stock would have to reach at least $221.39 (the option price + the strike price) at the expiration date for you to break even.
You would purchase this option if are bullish on Microsoft stock and you predict the stock will rise to above $221.39 per share by the expiration date.
Let’s compare the difference between buying the stock outright vs buying the option.
If you invested $2139 to buy the stock when it was $210 a share, and at the time of the sale, let’s say one year from now, the stock price reached $240, then you would have return of 14%.
On the other hand, if instead you bought the option, and the stock price reached $240 at the time of the expiration date, then the value of your option would be $4000. Compared to your initial investment, that provides you a return of 87%.
You can learn more about options in my article here.
Sounds good right?
But the same way leverage increases your gains, it can conversely increase your losses. If the stock price was less than the strike price of $200 at the time of the option expiration, then the option would have expired worthless and you would have lost your entire $2139 investment. Ouch!
Leveraged ETFs
Leverage ETFs seek to mimic the performance of a benchmark by a multiple.
For example, Ultrapro S&P 500 (Ticker symbol UPRO) seeks to correspond to 3X the daily performance of the S&P 500. In theory, when the S&P 500 increases by 1%, the fund should return close to 3%.
Do note that leveraged funds like these carry substantial risk.
Because of compounding daily returns, your returns may be much different from what you’d expect over the long run.
For example, let’s say the S&P 500 stands at 1000. It drops 10% in one day, then gains 10% the next day. It will end up at 990, which is a total two day loss of 1%.
Now let’s say that UPRO perfectly mimics 3X the performance of the S&P. UPRO also stands at 1000 in this example. It drops 30% in one day, then gains 30% the next day. It will end up at 910, which is a total two day loss of 9%.
You would have expected a two day loss of 3% right? But the actual loss was 9%. Imagine this happening on a daily basis. Over time, your results could vary quite differently from your expectations.
Here’s UPRO vs. the S&P 500 index over the past year:
The S&P 500 experienced a 16.14% gain over that time period.
You would expect a 3X leveraged fund to produce 3X the returns, or 48.4% right?
However UPRO only gained a 10.08% over the same time period! Does that sounds like a good investment to take on additional risk for less returns?
Most managers would not recommend investing a significant portion of your portfolio in leveraged ETFs, if at all.
Putting It All Together
Leverage is like trying to run your hands across the belly of a cat. It can bring immense euphoria, or it can it suddenly sink its painful teeth into you.
There is a cost associated with employing leverage: In margin trading you have to pay margin interest. There is also downside risk of having to cover a margin call if your equity drops too low.
In options trading, you have to pay the premium for the option. There is also downside risk of your option expiring worthless.
With leveraged ETFs, you could in theory maximize your returns. But since returns are compounded daily, your results could vary wildly from your expectations. Furthermore, there is tremendous downside risk during a market downturn.
With these caveats, leverage can still be a useful tool in your portfolio.
I’m still learning how to use leverage in a meaningful way while not taking on excess risk.
Lifecycle Investing by Ian Ayres and Barry Nalebuff is a great resource to get started on learning how and when to use leverage to maximize the size of your portfolio at a similar risk profile.
Let me know your thoughts!
Do you use leverage in your portfolio?
