When it comes to the power of 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 is just a fancy word for 'debt,' can indeed move worlds of money — if used properly. In this tutorial, I explain the most common ways individuals use leverage to juice their portfolios' returns.
Before you continue, keep in mind that investment leverage is not for conservative investors, the faint of heart or neophytes 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 losses.
Investment leverage comes in many forms, but debt, margin, options, and futures are its most common manifestations. We'll run the gamut of investing strategies, from no leverage to maximum leverage, with a candid examination of the pros and cons of each tactic.
Let the Company Do the Borrowing for You
There are clear benefits to owning something outright. For example, stock ownership conveys to the stockholder an actual share of the company, certain voting rights (depending on the stock) and, if available, dividends.
On the other hand, without using leverage, the only source of profit is the asset's potential increase in price and any income it throws off.
Leverage can be used at the individual level (we'll talk more about that later), but a good way to harness the power of debt without going into debt yourself is to buy a stock of a company that uses leverage at the corporate level. Corporate leverage is a powerful driver because it directly multiplies the corporate earnings of the company, which in turn drives stock prices.
When a company uses debt, more of its top line revenue growth flows through to its bottom line earnings number. And when you break down stock investing to its essence, a stock's value is solely dependent on the present value of the future earnings that will be generated by the company.
A good way to illustrate the concept is to examine the difference between owning gold and owning gold mine stocks.
An investor who buys gold outright owns an asset that will fluctuate in value. If you buy an ounce of gold at $1,000 and the price goes up to $1,100, you've just captured a +10% return. Not too bad. And chances are good the price of your asset won't fall all the way to zero, so the limited upside you're exposed to is balanced out by the limited downside risk. Un-leveraged positions are inherently conservative.
But if you own gold stocks and the price of gold goes up, the notion of 'operating leverage' comes into effect. A bump in gold prices will likely exert an exponentially huge boost on a gold producer's top line revenue. And because the producer doesn't have to put a whole lot of additional labor or capital into digging out increasingly valuable gold, its EPS should go up and take the stock's share price with it. At +10% increase in the price of gold should eventually lead to a more extreme price movement in the price of gold mining stocks because the gold miners have debt on their balance sheets.
Nathan Slaughter, Chief Investment Strategist of StreetAuthority's Market Advisor, wrote the following in a great piece about gold miners:
'[I]f you're looking to amplify your exposure to rising gold prices, why not go right to the source? Whenever gold prices are on the move, shares of gold producers like Goldcorp usually behave like bullion on steroids.'
Of course, the only rational reason to invest in gold stocks is if you have determined that the actual price of gold will rise. If you think that gold prices will drop, don't invest in gold stocks, because doing so equals a bet on higher gold prices.
Using Loans & Lines of Credit
The simplest and easiest form of investment leverage is through a loan or a line of credit.
To better understand how leverage amplifies returns, consider a common form of leverage: the home mortgage.
Here's a hypothetical return calculation: You decide to buy a $100,000 house with a $10,000 down payment and a $90,000 mortgage. The $10,000 is your equity investment in the home, and the rest of the purchase price is covered by the bank's $90,000.
If the home's value increases to $110,000, you're able to pay back the $90,000 bank loan and keep the remaining $20,000. You made a +100% return on your $10,000 investment.
Had you purchased the house with 100% cash, you would have made $10,000 on your $100,000 investment, a return of only 10%. [The rate of return calculation is ($110,000 - $100,000) / ($100,000) = 10%]
Getting back to stocks, let's say you have a hot tip on a stock you’re convinced will move dramatically upwards in a short amount of time. You could borrow the money to buy the stock, sell the stock before the loan is due, and pocket the profits (assuming the stock has gone up).
As a rule, stockbrokers enforce a 'no credit card' policy for buying stocks, to protect average investors from getting in over their heads. But that only applies to direct card purchases. There is nothing to prevent you from using a line of credit or cash advance from your credit card to buy stocks. That being said, you have to make sure that the return on your investment exceeds the interest and transaction fees incurred by borrowing the money.
The advantage of using 'plastic' as investment leverage: 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.
Personally, I don't recommend this strategy, but talented investors with intestinal fortitude sometimes use it to magnify profits. Proceed with caution.
Buying on Margin
Most brokers will let you set up a margin account, which allows you borrow money from the broker at a pre-set interest rate. Investors can generally borrow up to 50% of the cost to purchase stocks.
Let's assume you have $10,000 to invest and you use it to buy 500 shares of a $20 stock. If the stock's price goes up to $25 in 12 months, you end up with a $2,500 gain and a +25% return. That's your un-levered return.
Now, let's apply some leverage and see what happens.
Assume you still have $10,000 to invest, but your broker allows you to borrow up to 50% of any stock purchase at an interest rate of 10%.
Now you can buy 1,000 shares at $20 per share, for a total investment of $20,000 ($10,000 borrowed and $10,000 cash). The stock goes up to $25 per share and you cash out your shares for $25,000. You pay back $10,000 to your broker, plus $1,000 in interest. The $4,000 profit on your $10,000 investment is a whopping +40% return.
Again, I generally dissuade average investors 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, so let's look at an example from the flip-side.
One of the worst things that can happen to an investor is receiving the dreaded margin call from his or her broker. A margin call is a brokerage firm's demand that a client deposit cash into their account to bring the account balance up to the minimum maintenance margin requirement.
Investors must put up a minimum initial margin of 50%, a rule enforced by the Federal Reserve. Furthermore, a 'maintenance margin' of at least 25% must always be maintained. The maintenance margin protects the broker if the value of your investment declines.
If your 'equity' in value of your securities drops below the maintenance margin of 25%, your broker will send you a notice -- a 'margin call' -- that requires you to either liquidate your position or inject more cash into your account.
You can calculate the price to which your stock needs to fall before getting a margin call by using the following formula:
((# shares * price) - amount borrowed) / (# shares * price) = maintenance margin requirement
Using our example, if we have a 25% maintenance margin, we will get a margin call when the price of our stock falls to:
1,000P - 10,000 / 1,000P = .25
1,000P - 10,000 = 250P
750P = 10,000
P = $13.33
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. Depending on the terms of the margin agreement, this can even be done without your permission. Always examine the fine print of your broker agreements.
The orgy of margin buying during the 1920s boom helped precipitate the Crash of 1929 as thousands of investors became unable to make their margin calls. Back then, margin requirements were quite lenient and investors could purchase huge blocks of stock with very small upfront investments.
When the stock market began its death spiral in 1929, scores of investors got margin calls. They were forced to deliver additional money to their brokers or their shares would be sold. Because most individuals were leveraged to the hilt, they didn't have the money to cover their leveraged positions, which force brokers to sell their shares. The selling precipitating further market declines and more margin calls…and so on.
note that leverage can shorten your time horizons and as such, it doesn't give you the long-term time to bounce back. Even if your depressed stock eventually gets to your $25 target, the market and the margin calls can wipe you out before your analysis is finally vindicated.
Before you read any further, make a cup of coffee. For the uninitiated, options trading can get complicated.
An option is a contract that gives its owner the right (but not the obligation) to purchase or sell an underlying asset at a specific price, on or before a certain date.
Here's a trick to understanding an option: it's just another security, just like a stock or bond. An option has a price and trades on an exchange, just like a stock or bond.
That said, an option is a contract tied to an underlying asset (like a stock or stock market index). Hence, they're categorized as 'derivatives,' because options derive their value from something else.
Options come in two flavors: calls and 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 calls, it's the price it must fall below. These events must occur prior to the expiration date.
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. Accordingly, there are four types of players in options markets: buyers of calls; seller of calls; buyers of puts; sellers of puts.
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.
Assume you buy 1 call option. The option controls 100 shares of a stock. The option has a strike price of $9 per share. If the current market price is $10, the total market value of the stock is $1,000 ($10 * 100 = $1,000), but with your option, you have the right to buy the stock for $900 ($9 * 100 = $900). The value of your option is $100.
If the market price rises to $11 per share, the market value of 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 will expire worthless and you lose 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.
Buying & Selling Futures Contracts
Futures are contracts to buy or sell stocks, bonds, financial instruments, currencies, or commodities at a stated price at a stated time in the future. You can buy or sell the contract at any time, but unlike an option, a futures contract can't be exercised prior to its expiration date.
But like an option, when you buy or sell a futures contract, you're not buying or selling the underlying asset. The futures contract is a derivative that derives its value from the price movement of the underlying asset.
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) 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. (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.)
A futures contract is made up of two positions: long and short. If you're long, you've agreed to purchase the asset when the contract expires. If you're short, you've agreed to sell the asset 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.
Most exchanges require traders to post margin of only 5%, which means to make a trade, a trader only has to put up 5% of the contract value. With a relatively small amount of money, you can control a large quantity of the underlying asset. That's a small stake, because as we all know, prices can easily and quickly move by much more than 5%, even in a day's time.
To make it even more confusing, the term 'margin' does not mean 'borrowing' in the futures market. As we'll discuss below, futures positions are settled at least once per day so a trader can't build up a huge loss without having the money to back it. In the futures world, margin acts more like earnest money. The margin posted by traders is a sign they're acting in good faith and will fulfill the terms of the contract once they reach the expiration date.
As with options, a futures contract uses leverage that can turn a small bet into a very large win -- or loss. As mentioned above, to prevent traders from defaulting on bad bets, each position is settled at the end of the day and if one party falls below the maintenance margin, he or she gets a margin call.
The futures market can be confusing, so here's a simplified example, for illustrative purposes:
It's January 1. Your research tells you that the price of oil will fall to $60/bbl within the next six months. The futures market is pricing oil for July 1 delivery at $80/bbl, so you sell a contract on January 1, promising to deliver 1,000 barrels of oil on July 1 at the current futures price of $80/bbl. You are 'going short.'
To enter the contract, you need to deposit 5% of its value with the clearinghouse. The clearinghouse is a third-party that acts as a middleman to ensure that traders don't default on their futures contracts. The clearinghouse is there to make sure the futures market runs smoothly.
Your July crude oil contract is worth $80,000 at January 1, so you make an initial margin deposit of 5%, or $4,000, with the clearinghouse. The buyer of your contract, the long position, does the same.
Assume that the price of oil for July delivery does not move for a whole month, but on February 1, rumor of an increase in economic activity causes July oil to jumps to $82.
You're obligated to sell oil at $80/bbl, so your short position just lost $2,000. Your margin balance is now $2,000 and you've experienced a -50% loss.
But let's also look at it from the buyer's end. The buyer's long position just increased by $2,000. His margin balance is now at $6,000, for a tidy +50% profit in one month.
Assume again that the price of oil for July delivery does not move for a whole month, but on March 1, economists believe we're entering a double-dip recession. Oil for July delivery plummets to $70/bbl.
Now because we've already market the position to the market price of $82/bbl, your short position just increased in value by $82,000 - $70,000 = $12,000. You've deposited $4,000 total with the clearinghouse, so your total return-to-date is ($12,000 - $4,000) / $4,000 = +200%.
But the long position has lost -$12,000. The buyer's $6,000 is whisked away and he is now -$6,000 in the hole. Plus, he'll get a margin call to bring his margin back up to the original $4,000, meaning he'll need to put up an additional $10,000 if he wants to continue owning the contract. His return would be ($4,000 - $14,000) / $14,000 = -71%
Note that the absolute amounts gained and lost is the same for both side, just with opposite signs. The short position invested $4,000 and gained $8,000. The long position invested $14,000 (because he got a margin call) and lost $8,000. When the long position wins, the short loses in the same amount, and vice versa. The clearinghouse enforces the daily settlement (and sometimes more than once daily) to prevent one side from building up a huge loss that cannot be collected.
And we thus return to a key point that bears repeating: a futures contract is just that, a contract. In the above examples, you never really bought any actual oil or stocks. You buy and sell contracts that allow you to control the underlying asset, but cash is almost always the only thing that is exchanged between the parties.
This tutorial is merely an introduction to different ways to use 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.
On the other hand, if all of these concepts make your head swim, here's some common sense advice: if you want to buy an asset for logical reasons that are tied to its fundamentals, just buy it directly and wait until it does right by you.
[Leverage is a oft-used tactic in currency trading (Forex). If your portfolio needs the diversification benefits that Forex offers, click here to learn The Basics of Trading Forex.]