Leverage: Reducing Investment Risk Or A Double-Edged Sword?

Leverage is a tool used by investors and companies to generate greater returns on their assets. It involves using borrowed capital or debt to undertake an investment or project. While leverage can amplify returns, it can also increase the potential for losses. This is because the investor or company not only loses the money they initially invested but also owes the lender additional money.

Leverage is often used to increase buying power and gain exposure to assets that would otherwise be unaffordable. It can also be used to diversify investments and spread risk. However, it is a complex strategy that can lead to increased risk and requires careful management.

This paragraph will discuss the risks and benefits of using leverage as an investment strategy and provide an overview of when it may be appropriate to use leverage.

Margin trading

Benefits of Margin Trading

• Leverage: Margin trading allows investors to borrow funds to purchase securities, increasing their buying power beyond their cash equity. This leverage has the potential to lead to greater returns, making it attractive to investors seeking to maximise profits.
• Enhanced returns: Using borrowed funds can amplify returns if investments perform well. Margin trading allows investors to control a larger investment portfolio with relatively small capital, substantially enhancing profits in a rising market.
• Flexibility: Margin trading provides flexibility to quickly capitalise on market opportunities. The additional buying power enables investors to respond swiftly to favourable market conditions, potentially enhancing investment outcomes. This is particularly beneficial in fast-moving markets.

Risks of Margin Trading

• Magnified losses: While leverage can enhance returns, it also magnifies losses. If the market moves against an investor's position, losses can far exceed the initial investment, leading to significant financial setbacks.
• Risk of margin calls: A margin call occurs when an account's value falls below the broker's required minimum equity level. This triggers the obligation to deposit additional funds or sell securities to cover the deficiency. Failing to meet a margin call can result in the forced sale of assets at an unfavourable time.
• Interest costs: Borrowing on margin incurs interest costs, which can erode profits over time. These ongoing expenses must be factored into the investment strategy to ensure potential returns outweigh the costs.
• Emotional demands: Margin trading can be emotionally demanding, as the pressure to manage borrowed funds may affect decision-making. Emotional factors can cloud judgment, leading to impulsive decisions and potentially poor trading choices.
• Regulatory limitations: Margin trading is subject to regulations aimed at protecting investors and maintaining market stability. Ignoring or violating these guidelines can lead to penalties, account closures, or legal consequences.

Strategies to Manage Margin Risks

• Set stop-loss orders: Use stop-loss orders to automatically sell securities when they reach a specified price, helping to limit losses in volatile markets.
• Diversify your portfolio: Spread investments across different asset classes to reduce risk exposure. Diversification cushions the impact of losses in any single investment, providing a more stable overall portfolio.
• Regularly monitor your margin account: Keep a close eye on the margin account to ensure it remains above the required equity levels. Regular monitoring allows for timely actions to mitigate potential risks and ensure investments align with the financial strategy.

While margin trading can provide enhanced returns and flexibility, it is crucial to understand and carefully manage the associated risks.

Options trading

Options are a type of contract that gives the buyer the right to buy or sell a security at a specified price at some point in the future. Options trading can be more complex and riskier than stock trading. It requires a good grasp of market trends, the ability to interpret data and indicators, and an understanding of volatility.

One of the biggest benefits of trading options is that options contracts themselves are a leverage tool. They allow you to multiply the power of your starting capital. The cost of options contracts is typically much lower than the cost of their underlying security, yet you can benefit from price movements in the same way.

For example, let's say you have $1,000 to invest in Company X stock, which is trading at $20. With this money, you could purchase 50 shares. If the stock price increases by $5 to $25, you would be able to sell those shares for a total profit of $250. Now, let's assume you decided to invest in call options on Company X Stock, trading at $2, with a strike price of $20. If the contract size was 100, you could buy five contracts at $200 each, meaning you effectively have control over 500 shares. With the price of Company X going up to $25, you would make a lot more money through selling your options at a profit than the $250 you would make in the previous example.

This is the principle of how leverage works in options trading. The higher the leverage factor, the greater the potential profits, but also the greater the potential losses. Leverage allows you to make significant profits without needing a lot of starting capital, but it's important to recognise the increased risk.

The calculation for leverage is as follows:

> (Delta Value of Option x Price of Underlying Security) / Price of Option

For instance, if the delta value of an option is 0.6, it will move $0.60 for every $1 move in the price of the underlying security.

When trading options, it's important to understand how to calculate the leverage of taking any given position by using the delta value, and to be aware of the role that moneyness plays in leverage. Out-of-the-money contracts will have the highest leverage, followed by at-the-money options, and then in-the-money contracts, which have the lowest leverage.

Risks of Leverage

Although leverage can enhance returns and improve diversification, it also introduces unique risks. Performance risk is the risk of losing more money than you would have if you had not used leverage. This can occur when there are existing exposures, highly correlated asset classes, or uncorrelated asset exposure.

Path-dependency risk is the more subtle risk that an investor is knocked out of their position due to adverse events, such as a margin call that the investor can't satisfy, leading to the position being liquidated.

Leverage can also amplify downside risk, resulting in losses greater than your initial capital investment. Additionally, brokers and contract traders often charge fees, premiums, and margin rates, which can add to your losses.

Advantages of Leverage

Leverage can be a powerful tool when investing, as it allows you to turn relatively small amounts of capital into significant profits. It can also reduce barriers to entry by allowing investors to access more expensive trading opportunities.

For companies, leverage can be used to finance their assets and influence growth instead of issuing stock to raise capital. It can be a strategic way to meet short-term financing needs for acquisitions or buyouts.

Disadvantages of Leverage

As well as amplifying potential losses, leverage can be more expensive than other types of trading due to fees, margin rates, and contract premiums. It can also be more complex, requiring additional capital and time based on portfolio needs.

Leverage is best used in short-term, low-risk situations where high degrees of capital are needed. It should be used wisely, as it has been found lurking at the scene of many major financial catastrophes in history.

Leveraged ETFs

The Benefits of Leveraged ETFs

• Greater potential returns: Leveraged ETFs offer the potential for significant gains that exceed the tracked index or assets.
• Diversification: Investors have a wide variety of securities to trade using LETFs, allowing for greater diversification.
• Hedging: LETFs can be used as a hedge against potential losses, especially in the short term.
• Inverse investing: LETFs can also be structured as inverse ETFs, allowing investors to profit when the market is declining.

The Risks of Leveraged ETFs

• Magnified losses: While leveraged ETFs can amplify gains, they can also lead to significant losses that exceed the underlying index.
• Higher fees and costs: Leveraged ETFs typically have higher fees and expense ratios compared to traditional ETFs due to the costs associated with derivatives and margin.
• Not suitable for long-term investing: The daily rebalancing and reset mechanisms of LETFs make them unsuitable for long-term investment strategies.
• Volatility: The sensitivity of LETFs to market fluctuations can result in higher risk and volatility compared to traditional ETFs.

In summary, leveraged ETFs can be a powerful tool for short-term traders seeking to maximise returns, but they come with higher risks and costs. Investors should approach LETFs with caution and a thorough understanding of their mechanics and potential impacts on their portfolios.

Increased buying power

Leverage can give you increased buying power, which is why it can amplify your returns. However, this isn't always the main goal. For example, when buying real estate, a mortgage gives you leverage to afford a more expensive home than if you paid in cash. Even if you could afford to buy the full asset in cash, you might prefer to use leverage so that you still have some buying power to put toward other assets.

"When making a purchase, investors can use a combination of both their own equity capital and leverage to expand the affordability of any investment," says Keith Carlson, CEO and managing partner of Roebling Capital Partners. "Simply put, debt and equity availability will always be greater than equity alone; what one can purchase using both will always be more substantial."

Having more buying power through leverage isn't necessarily just used to take on risk. Some investors do so to spread out their investments across multiple asset classes to try to increase diversification while still gaining the potential for amplified returns. Also, leverage through futures and options can help you diversify in the sense of betting on different scenarios, like buying puts to protect against the possibility of a stock market downturn.

Leverage can be a powerful tool for investors, unlocking opportunities to enhance returns and improve diversification. It involves borrowing capital or using various financial instruments to increase an investor's buying power in the market. This increased buying power allows investors to access more expensive investment options and make larger investments than they could with their own capital.

For example, an investor with limited funds may use leverage to purchase a property worth $500,000 by putting down a $100,000 down payment and borrowing the remaining $400,000. If the property value increases by 10%, it would be worth $550,000. After paying off the $400,000 loan, the investor would be left with a $50,000 profit, representing a 50% gain on their initial investment. In contrast, if they had purchased the property without leverage, the same 10% increase in value would have only resulted in a 10% gain on their investment.

Leverage can also be used in the stock market through margin trading, where investors borrow money from their broker to invest in stocks. For instance, an investor could use $5,000 of their own money and borrow an additional $5,000 from their broker to purchase $10,000 worth of stock. If the stock value increases by 30%, they would make a $3,000 profit, resulting in a 60% gain on their initial investment. Without leverage, the same increase in stock value would have only yielded a 30% gain.

Options trading is another way to access leverage without borrowing money. An options contract allows investors to control a larger position for a fraction of the cost. For example, an investor could spend $100 on a call option for a stock priced at $100 with a strike price of $101. If the stock price increases to $110, the investor gains $900 minus the premium paid. Without leverage, the same increase in stock price would have resulted in a much smaller gain.

Futures contracts provide similar leverage, with the size of the leverage varying depending on the underlying asset. For instance, a standard futures contract for crude oil typically represents 1,000 barrels, but investors can gain exposure to this asset by paying a fraction of the cost, usually around 10%, as the margin requirement. This allows investors to gain or lose based on the price movements of the underlying asset.

While leverage can provide increased buying power and the potential for amplified returns, it's important to remember that it also comes with higher risks. Leverage can magnify losses, and investors may end up losing more than their initial investment. Therefore, it's crucial to carefully consider the risks and rewards of leverage before employing this strategy.

Diversification

A diversified portfolio contains a mix of distinct asset types and investment vehicles. This can include stocks, bonds, real estate, or cryptocurrency, as well as investments in different countries, industries, company sizes, or term lengths for income-generating investments.

The rationale behind diversification is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security. By investing in a variety of assets with different expected risks and returns, investors can position their portfolio to be more resilient during challenging market periods.

For example, if the price of oil falls, investments in the oil and gas industry may see a decline in share prices. However, if investors have also invested in other industries or asset types, the potential decline in energy stocks may be offset by gains in other parts of their portfolio.

It's important to note that diversification does not guarantee returns or protect against losses. While it can help mitigate some risks, it cannot eliminate all risks, especially systematic risks such as inflation, interest rates, or geopolitical events, which can cause widespread economic and market instability.

When implementing a diversification strategy, it is crucial to consider the correlation between different investments. Correlation indicates the concurrent performance patterns of two securities or asset classes. If all investments in a portfolio are positively correlated, they are likely to trend up or down simultaneously, resulting in a lack of effective diversification.

To enhance diversification, investors can employ various strategies, such as diversifying across asset classes, within asset classes (by industry, fixed-income investments, or funds), by location (including global exposure), and by exploring alternative investments such as REITs, commodities, or reinsurance.

Additionally, regular rebalancing of the portfolio is necessary to maintain the desired level of diversification, as certain investments will gain value while others decline over time. Investors should also consider their risk tolerance and investment timeframe when determining their diversification strategy.

Frequently asked questions