A guide to investment leverage in its many forms: debt, margin, options and futures.
When it comes to the power of investment leverage, the ancient Greek mathematician Archimedes put it best: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
Leverage, which in investment terms is just a fancy word for “debt,” can indeed move worlds of money if used properly.
Keep in mind, though, that investment leverage is not for the faint of heart, nor for neophyte investors who don’t fully understand what they’re doing. Just as leverage can multiply your gains in a short amount of time, it can do the same in reverse, and trap you in a dizzying downward spiral of fast losses.
Here’s a basic guide to the many manifestations of investment leverage (debt, margin, options and futures, etc.) with a candid examination of the pros and cons of each tactic:
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Direct Borrowing Investment Leverage
The simplest and easiest form of investment leverage is debt, through a credit card or a loan. Let’s say you have a hot tip on a stock that you’re convinced will move dramatically upwards in a short amount of time. You could buy the stock with your VISA or MasterCard, then sell the stock before the card’s grace period is over. If the stock goes up, you pay off your card and pocket the profits.
The advantage: Credit card debt is unsecured and poses no danger to your assets. The disadvantages…well, they’re obvious. You could be very wrong about your hunch and get stuck with a lousy investment, as well as a big fat credit card bill. Investors with intestinal fortitude sometimes make money this way. We don’t recommend this strategy. But if you’re the gambling type, have at it—the odds are still better than Vegas.
Buying on Margin
A broker will let you set up a margin account, with which you can borrow money from the broker at a pre-set interest rate. Investors are allowed to buy on margin, borrowing from their broker up to 50% of the purchase cost.
Again, most average investors should refrain from deploying this tactic. If the stock of an inherently healthy company runs into a rough patch, margin debt can turn your investment into a quickly developing disaster. Consider the orgy of margin buying during the 1920s boom, which helped precipitate the Crash of 1929 as thousands of investors became unable to make their so-called “margin calls.”
A margin call is a notice from a broker to a customer, demanding the deposit of cash or securities for the purchase (or short sale) of securities to cover an adverse price movement. If you don’t have the wherewithal to cover a margin call, the experience can be quite unpleasant. If you can’t cough up the money, the brokerage has the right to sell your securities to boost your account equity.
An option is a binding, specifically worded contract that gives the buyer the right to purchase or sell an underlying asset at a specific price, on or before a certain date. The investor has the right—but not the obligation—to buy. Here’s a trick to understanding an option: It’s just another security, just like a stock or bond.
The right, but not the obligation, to take action is a key distinction. Upon the expiration date, you could always decide to take no action, at which point the option becomes worthless. If you make this decision, the option becomes worthless and you lose all of your investment, which is the money that you used to buy the option.
Also, remember that an option is only a contract that’s tied to an underlying asset (such as, say, a stock or stock market index). Hence, they’re categorized as “derivatives,” because options derive their value from something else. Derivatives have acquired a pejorative reputation of late, because incredibly complex derivatives helped fuel the financial calamities of 2008.
Options come in two flavors: puts and calls. A put gives the owner the right to sell the underlying asset, and a call gives the owner the right to buy the underlying asset.
If you think the price of a certain asset will increase substantially before the option expires, you’d purchase a call option. If you think a stock will dramatically drop in value, you’d purchase a put. You can also sell, or write, puts and calls. Accordingly, there are four types of players in options markets: buyers of calls; seller of calls; buyers of puts; sellers of puts.
The strike price (sometimes called the “exercise price”) is specified as part of the option contract. The strike price is the price at which an underlying asset can be purchased or sold. For calls, this is the price an asset must rise above to make money; for puts, it’s the price it must fall below. These events must occur prior to the expiration date.
Options take advantage of leverage because they allow you to control a large number of shares with relatively little money—a great example of Archimedes’ lever.
Stock Options Example
Assume you buy one call option. Each option controls 100 shares of a stock. The option has a strike price of $9 per share. If the current market price of the stock is $10, the total market value of 100 shares of the stock is $1,000 ($10 x 100 = $1,000). But with your option, you have the right to buy the stock for $900 ($9 x 100 = $900). The value of your option is $100.
If the market price of the stock rises to $11 per share, the market value of 100 shares the stock rises to $1,100. Because your exercise price remains the same ($900), the value of your option is now $200, a 100% jump produced by only a 10% increase in the price of the underlying stock.
The overriding point is this: There’s significant leverage in owning options. A small or modest bet can pay off with a huge win—if you’re right. If you’re not right, your option can lose as much as 100% of your investment.
Aside from their complexity, there’s another caveat about options: time is not your friend. If your option expires in three months, you not only need to be right about your hunch, but you need to be right very soon. Within such a short window, conditions can change considerably, putting you at the mercy of the market’s vicissitudes.
Futures are contracts to buy or sell stocks, bonds, or commodities at a stated price at a stated time in the future. These commodities include pork bellies, gold, currency, corn, wheat, orange juice, etc. (It all brings to mind the 1983 movie comedy “Trading Places,” starring Eddie Murphy and Dan Aykroyd. If you want a tutorial on futures contracts that’s also hilarious, watch this classic film.)
Most commodity futures contracts come due within three or six months. You can buy and sell single stock futures or stock index futures, which are contracts based on the performance of a broad index such as the Standard & Poor’s 500.
When you purchase or sell, say, a stock future, you’re not buying or selling the underlying stock. You never really own the stock. You’re engaging in a futures contract, which is an agreement to buy or sell the stock certificate on a certain date at a fixed price.
A futures contract essentially entails two positions: long and short. If you’ve entered into a long position, you’ve agreed to purchase the stock when the contract expires. A short position stipulates the inverse: You’ve agreed to sell the stock when the contract expires. So, if you’re convinced that the price of your stock will be higher in three months than it is today, you take a long position. If you think the stock price will be lower in three months, you choose to go short.
Futures contracts are traded in freewheeling “trading pits” at exchanges worldwide. It’s in these frenetic environments where traders determine futures prices, which change from moment to moment. For a snapshot of capitalism at its most raw, visit The Chicago Board of Trade (CBOT). Established in 1848, the CBOT is the world’s oldest futures and options exchange. More than 3,600 CBOT members trade in excess of 50 different futures and options contracts.
Most commodity and currency futures have a margin of 5%, which means to make a trade, you only have to put up 5% of the contract value. That’s a small stake, because as we all know, prices can easily and quickly move by much more than 5% in only a day’s time.
And there’s the rub: a leveraged bet of 5% is much smaller than the margin debt with which you’re allowed to buy stocks, as mentioned above. A percentage that small doesn’t allow you to ride out short-term fluctuations. It’s possible to bet hideously wrong.
As with options, a futures contract uses leverage that can turn a small bet into a very large win—or loss. In fact, futures are even riskier than options, because with the latter, an options buyer’s worst-case scenario is losing the original investment. An investor in the futures market can lose a lot more. Then again, a single futures contract can rise in value by several thousands of dollars each day.
This tutorial is merely an introduction to these complex forms of investment leverage. If the prospect of parlaying a small amount of money into huge wins has whetted your appetite for more, consult your broker or financial advisor for more information.
What else would you like to know about investment leverage?