What Is Leverage When It Comes To Investing?

Leverage is a word in the investment world that triggers extreme reactions. Some love it, some fear it. And many don’t even have an inkling what it is. In any case, I am sure you hear of funds making phenomenal returns in the orders of hundreds of percent. Yes, they used leverage. Similarly, you must also hear of funds that went bust overnight. And yes, they too used leverage.

What is Leverage?

As grand as the word may sound, leverage is just a simple concept. It means borrowing more money to increase the size of your positions. The good thing about it? You get to amplify your profits. And the bad thing? You also magnify your losses. It is a double-edged sword. To be fair, that is how the world works. You can’t possibly expect only greater rewards from increasing your bets without commensurately higher risks.

Where Can We Borrow More Funds To Invest?

There are simple ways we can increase the size of our investments beyond the cash we have.

1. Margin Account

In a margin account, the broker extends a loan to you to purchase securities. These securities are in turn held as collateral against the loan. And in the meantime, the broker charges you an interest on the borrowed funds. The interest charged vary from broker to broker, but is usually pegged to a reference rate plus a spread.

2. Leveraged products

Alternatively, you can invest in leveraged products. Leveraged ETFs providing 2x-3x of leverage are common nowadays giving retail investors easy access to leverage. But do not not be mistaken that it will be cheaper to do so. These ETFs still pay whatever financing costs is required for them to replicate the required market exposure. And on top of that, these ETFs tend to have higher expense ratio.

Other products include CFDs, Futures and Options. Again, the leverage don’t come free of charge because financing costs are already baked into the prices. But they tend to be lower than what the broker charges as the latter comes with a large spread especially when you are a small player. Large players such as commercial funds tend to go for derivatives such as futures as they are more cost effective, liquid, and allow a higher degree of leverage.

Options, on the other hand, are more complicated. When you purchase an option, you are paying not just for upside potential, but for downside protection as well within a limited time frame. And when you sell options (in industry, we term this as write options), you are doing the reverse or basically selling downside protection. They are non-linear products and a host of other factors such as its implied volatility, time to expiry, strike and where its underlying currently trades plays a role in determining its price. So they are a different breed altogether.

3. External borrowing

Of course, you can always borrow from others like your family or friends. There is also nothing stopping you to take a loan from the bank using your house as collateral. After that, you can take on further leverage after depositing these freshly borrowed funds with your broker. Leverage on leverage. Sounds cool? But if you don’t know what you are messing with, that is a quick way to lose more than just your house and pants.

How Do We Measure Leverage?

As a general rule of thumb and assuming we take only long positions (i.e. no shorts), leverage can be calculated as follows:

Total Market Exposure / Net Liquidation Value

Total Market Exposure is the value of all your open positions.

Net Liquidation Value is what you expect to get back in cash after you (1) liquidate all the position; (2) receive all that are due to you such as accrued dividends; (3) pay up all outstanding fees/taxes, financing costs and; (4) return back what you borrowed.

Margin Financing Example

Let’s run through a scenario using a margin account. Assume you funded $200K in your the account and after that bought $300K worth of securities. So that effectively means you borrowed $100K from the broker, and your leverage at that point in time will be about 1.5x. See the table below. Cash is negative because you owe the broker $100,000.

Your leverage, however, fluctuates day to day based on how the market moves. If the value of your securities crash 10% or $30K from here, your leverage increases to 1.59x. Why? Because you lost 1.5x as much or 15% on your NLV.

And by the same measure, if the value of the securities go up by 10%, your leverage comes down and in this case to 1.43. Because you gain more, proportion wise, on your NLV.

So if you want to maintain leverage at a specific level, you have to increase or decrease the size of your positions periodically. When your portfolio sustain a loss, you size down as leverage goes up. Similarly, when your portfolio makes money, you size up as leverage goes down. In a way, you are selling into weakness and buying into strength. But such an approach, depending on how frequent you adjust your portfolio, can increase your transaction costs significantly.

How Are Interest and Leveraged Return Calculated?

Alright, there is no free lunch in this world. As mentioned earlier, there is a cost to borrowing unless you got a rich dad/mum providing you a perpetual interest free credit facility with no limits. But if not, you pay interest like everyone else.

The financing charges are more readily transparent if you are doing it through margin financing. As an example, Interactive Brokers use the effective Fed Funds Rate as the reference for funds borrowed in USD. At the point of writing, the effective Fed Funds Rate is 0.05% and the spread they charge is 1.5% for borrowings up to USD 100K. So if you borrow USD 100K or less, the financing charge works out to be 1.55% per year. The charge is calculated and accrued on a daily basis.

To illustrate the calculations, lets use back our earlier scenario where you funded $200K into your account and then borrowed another $100K to buy $300K of securities. And say after a day, the value of your securities rose by 0.1% making you a profit of $300. If there are no interests, you would have made:

$300 / $200,000 = 0.15%

However, we are not done yet because you got to deduct the interest charge which is:

$100,000 x 1/365 x 1.55% = $4.25

Hence, what you make for that day is a little lesser at $295.75. Based on that, your actual return for the day would be

$295.75 / $200,000 = 0.148%

For derivatives like futures and options, it is more difficult to see how much you are paying for financing. These charges are implicit as they are embedded into the prices.

Conclusion

This post covers the basic mechanics behind leverage — how you can access it, how to measure it, what it does and what are its direct cost. But the more interesting question is when do we use it and how much leverage should we take? I will look at that in my next post.

Until then, take care everyone.

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This article was first published on Investment Cache on 13 May 2020