Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest. Leveraged investing exposes an investor to higher risk.
Where does the borrowed capital come from? From any source potentially, but in this article, we'll compare three common sources: a brokerage margin loan, a futures product (such as an index of single stock future) and a LEAP call option. These forms of capital are available to virtually any investor who has a brokerage account. Understanding the alternatives is the first step to building the right leveraged investment, so read on to learn more about how to determine what kind of leverage to use in your portfolio.
Margin loans use the equity in an investor's account as collateral. They are provided by brokers and are heavily regulated by the Federal Reserve and other agencies, as the availability of easy investment credit was one of the factors that contributed to the 1929 stock market crash.
SEE: Margin Trading
Interest rates on margin loans are comparatively high and are usually tiered. For example, a large online broker may charge 7.24% on margin balances above $1 million, but 10.24% on balances below $50,000. Some online brokerages provide a less expensive margin and use it as a selling point.
The advantage of margin loans is that they are easy to use, and the capital can be used to purchase virtually any investment. For example, an investor with 100 shares of Coca Cola could borrow against those shares and use the proceeds to buy put options on another security. Dividends from the Coca Cola shares could then be used to help pay the margin interest.
An investor who uses margin can face significant financial risk. If the equity in the account falls below a predetermined level, the broker will ask the investor to contribute additional capital or liquidate the investment position.
The initial margin and maintenance margin serve as a cap on the amount that can be borrowed. A 50% initial maintenance margin requirement results in a maximum initial leverage ratio of 2 to 1, or $2 of assets for every $1 of equity. Of course, an investor that consistently uses the maximum margin available faces an increased risk of margin call in a market decline.
The minimums for both the initial and maintenance margin are set by the Securities and Exchange Commission (SEC). However, some brokers do provide customers with a way to bypass these minimums by providing certain accounts with portfolio margin. In these accounts, margin is based on the largest potential loss of the portfolio, as calculated by the underlying prices and volatilities. This may result in lower margin requirements, especially if hedging is used.
Stock and Index Futures
A futures contract is a financial instrument used to purchase a specific investment for a certain price at a later date. Financing costs are included in the price of the future, which makes the transaction equivalent to a short-term loan.
SEE: Futures Fundamentals
Futures are often associated with currencies, commodities and interest rates, rather than equities. However, in 2005, more than four billion of the almost 10 billion futures contracts traded that year were contracts on equity indexes.
Although these products have a reputation for being beyond the reach of the typical retail investor, companies are moving quickly to expand access. More online brokerages now provide access to futures, and less initial capital is now required to trade them. For example, an E-mini S&P contract can be purchased for less than $4,000.
Investment selection is also limited but growing. Futures contracts can be purchased on well-known indexes, such as the S&P 500 or Russell 2000, on some exchange traded funds such as DIA (DJIA tracker) and now on more than 400 individual stocks. Futures contracts on stocks are known as single-stock futures (SSF).
Futures contracts are a favorite with traders because of their relatively low bid-ask spreads and the high amount of leverage provided by the contract. Interests costs are also much lower than margin rates; they are calculated as the broker call rate minus the dividend yield paid by the underlying securities.
Every futures contract has a settlement date upon which the contract expires, but these dates are relatively meaningless, as most contracts are either sold or rolled forward to a future date.
Investors are required to maintain a cash position in order to purchase a future. This is often referred to as margin, but is actually a performance bond. This performance bond is equal to some percentage of the underlying, typically 5% for broad indexes and up to 20% for single stock futures. This provides leverage from 5 to1, to 20 to 1.
If the price of the underlying security declines, the investor will have to put up more cash to maintain his or her position. This is similar in practice to a margin call. This can make futures very risky. To prevent catastrophic losses, futures are often hedged with options.
Stock and ETF Options
Options provide a buyer with the right to buy or sell shares of a security for a specific price. Each option has a strike price and expiration date. Call options, or options to buy, have a built-in financing cost similar to futures. However, option pricing is primarily driven by seller risk, which is related to the volatility of the underlying investment.
SEE: Options Basics
Options play an important role in the market as hedging tools. The potential downside risk in a futures contract is very large, often many times the initial investment. Using options can limit this risk, at the expense of some of the potential appreciation.
Options are available for most large stocks and many popular ETFs. Index options are more specialized, and are not available at most brokers. There may be dozens or even hundreds of options available for a specific security, and selecting the appropriate one can be difficult.
Part of the challenge is the tradeoff between the initial premium, the leverage provided and the rate of time decay. At-the-money and out-of-the-money call options with closer expiration dates have the highest amount of leverage, but can lose value rapidly as time passes. The relative complexity of this can be discouraging for new investors.
Options expire, but can be rolled over to new expiration dates by selling the existing option and purchasing a new one. This can be costly, depending on the bid-ask spreads of the two options. It also results in the investor trading a higher delta option for a lower delta option.
The Bottom Line
Although futures products are still not available to many retail investors and futures contracts are not available on all products, it's very likely that access to these products will continue to increase. Futures provide investors with higher leverage at lower interest rates than margin loans, resulting in greater capital efficiency and higher profit potential.
However, some brokers have taken steps to make margin loans more competitive with futures products. These brokers are charging lower interest rates and are either lowering interest rates to the SEC minimums or introducing portfolio margin to bypass them altogether. Margin loans also allow a much broader selection of investments than futures.
Both margin loans and futures contracts leave investors exposed to considerable downside risk. Declines in the underlying security can lead to large percentage losses and may require the investor to immediately provide additional funds or risk being sold out of their position at a loss.
Call options combine the leverage and interest rates of futures with hedging in order to limit downside risk. Hedging can be costly, but can lead to higher overall returns, as it allows an investor to invest more capital rather than holding a reserve for catastrophic losses.
There are many tools available to leveraged investors and the selection is growing. As always, the challenge is knowing when and how to use each one.