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
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.

SEE: What does it mean when the shares in my account have been liquidated?

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.

SEE: A Beginner's Guide To Hedging

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).

SEE: Surveying Single Stock Futures

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.

SEE: The Importance Of Time Value In Options Trading

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.

SEE: Using Options Instead of Equity

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.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  3. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  4. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  5. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  6. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  7. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  8. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  9. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  10. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center