The Dangers of Leverage — and Some Solutions

Most investors and traders have heard of leverage, and can fall into two camps on the subject. Some believe that it is smart or sophisticated to invest using OPM (other people’s money), which just means borrowing to invest. Others see leverage as higher risk.

When you use leverage, the numbers seem compelling. The most popular form of leverage is to trade on margin. You borrow money from the brokerage house and double your potential investments. Brokerages are required to maintain 50 percent equity in margin accounts, so if you have $5,000 in cash, you can invest up to $10,000. Half of it is margin funds (borrowed money).

The power of leverage

So in support of leverage, here is the argument: If a stock is worth $50 per share, just buying 100 shares and using all of your cash,  you make $300 if the stock price goes up three points. But if you use margin and buy 200 shares, the same three-point rise brings in $600, or twice as much.

That sounds great. Where do I sign up?

But there’s a dark side…

But wait a minute. Now look at the other side of the leverage equation. If your $50 stock loses three points, you are down $300 and shares are only worth $47. If you used margin and bought 200 shares, the three-point drop takes your value down $600.

Something else also happens here. Your $10,000 investment fell to $9,400, but half of the original, or $5,000, was borrowed and you still have to pay that back. But based on current value of $9,400, you are only allowed to borrow half, or $4,700. So you will get a margin call, a demand for you to deposit $300 more in your account to maintain that 50% ratio between your money and your leveraged money.

Some safety measures

The truth is, leverage through a margin account increases your risk and can rapidly destroy your capital’s value if and when values fall. Here are some solutions to help mitigate that risk:

1. Buy safe value investments if you must use margin.

2. In volatile times, if you are allowed to trade options in your account, buy a put to protect your stock’s value (a put increases in value point for point with losses in stock that has fallen below the put’s strike price). This creates a form of insurance until the put expires.

3. Use call and put options to control 100 shares of stock but without having to buy 100 shares. Options can be bought for a very small price, about 5% of the value of stock, but their prices change in the same manner as 100 shares. You have to be knowledgeable in the options market before your broker will allow you to trade, but if you gain that knowledge, options can address the risk of leverage.

4. Experienced options traders may consider some additional strategies, including collars and synthetic stock positions.

5. Use stop-loss orders or trailing stops to curtail losses and reduce the impact of declining value in a margin account.

6. Finally, any investor can use mutual funds, ETFs (exchange-traded funds) and index funds as vehicles to spread risks, potentially reducing leverage risk.

The bottom line of leverage is this: Leveraged positions grow faster than all-cash, but they also lose value faster and can create serious problems in your margin account. If you cannot accept leverage risk, you should avoid it completely. If you can accept the risk, look for ways to hedge that risk.

Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes fulltime.