fbpx

What You Need To Know About Leveraging Investments

If you’re looking for ways to increase the return on your investments, leveraged investments may be a strategy you want to consider. While you do want to be prudent when taking on leverage for investment purposes, it’s important to remember that debt isn’t inherently a bad thing. In fact, good debt can help you achieve your goals more rapidly. Take a closer look at what leveraged investing is and why, if it’s used responsibly, it can be a great way to achieve your investment goals.

  • Leveraged investing is when you borrow money for investing purposes, speeding up the rate at which you can earn returns on any investment.
  • You can use several different types of debt as leverage for investing, including traditional loans, margin loans, futures products, and options contracts.
  • It’s important to carefully consider the interest rate for any loan since a high interest rate can offset potential gains and make an investment not worth the risk.

What Is Leverage in Investing?

Image via Unsplash by m_b_m

Leveraged investing is a strategy of using borrowed money to increase your return on an investment. If the return on the value you invest in the security is higher than the interest you’ll be required to pay for borrowing the money, you can earn a significant profit. That said, this type of investing does expose you to higher levels of risk.

Sources of Borrowed Capital

The borrowed funds can essentially come from anywhere. However, some of the most common sources are:

Traditional Loan

This type of investment is one that’s easiest for most investors to understand. Hypothetically, if an investor wanted to invest a large amount of money, they could reach out to their bank for a loan. If they had equity in their home, they could use that to keep the interest rate for the loan low.

While this is certainly one of the simplest methods for obtaining funds for a leveraged investment, banks can be wary of lending money to people for investment purposes. Additionally, if the investor doesn’t have equity in their home and the interest rates for the loan are high, the potential gains may not be high enough to make the investment worth it.

Margin Loans

With a margin loan, the investor uses the equity in their account as collateral for the debt. This type of loan is heavily regulated by the Federal Reserve since extending credit to too many investors was a contributing factor to the 1929 stock market crash. The initial margin plus the maintenance margin serves as a cap for the amount that the investor can borrow. For example, if an investor has a 50% maintenance margin requirement, there would be a maximum leverage ratio of $2 of assets that the investor holds for every $1 of equity.

The minimums for the maintenance margin and the initial margin are set by the Securities and Exchange Commission. That said, brokers do help customers find ways around the minimums by giving some of those accounts a portfolio margin. For these accounts, the margin would be based on the largest potential loss for the portfolio, which could result in lower margin requirements.

One of the primary advantages of taking out a margin loan is that investors can use that capital for almost any investment. The major drawback, though, is that investors who use margin loans could face a large financial risk. If the equity in the account falls under the predetermined level, the investor could be asked to contribute additional funds or liquidate their position.

Futures Contract

A futures contract is an agreement to buy or sell a commodity asset or security at a specific price within a predetermined period of time. Futures are usually associated with interest-earning instruments, commodities, and currencies, as opposed to equities. Investors must maintain a cash position to buy a future.

Though it’s frequently referred to as margin, in truth, it’s a performance bond. A performance bond is issued by a bank or insurance company that guarantees a contract will be filled. The performance bond is equal to a percentage of the underlying asset, usually between 5% and 20%.

Many investors prefer using futures contracts for leveraged investing since they have a low bid-ask spread and the contract provides high amounts of leverage. In addition, interest rates tend to be far lower. The largest drawback for using futures contracts to obtain funds is that if the price of the commodity or underlying security declines, then the investor will be required to contribute additional cash in order to maintain that position.

Stock Options

A n options contract gives a buyer the right to buy or sell shares of a particular stock for a predetermined price within a specific period of time. The price that’s set for the contract is called the strike price, and when the buyer takes action by buying or selling the shares listed in the contract, that’s referred to as exercising their option. A buyer must exercise their stock option before the expiration date, or the contract will expire.

Investors can use stock options as leverage when they speculate that a particular stock will gain or lose value. If an investor believes that a stock is going to go up in value, they will buy a call option, earning the right to purchase the asset at the strike price before the expiration date. If they think the stock is going to go down, then they might buy a put option, which gives them the right to sell an asset at a specific price before it expires.

Leverage Versus Margin

While leverage and margin are interconnected, they aren’t the same thing. Leverage refers to actually taking on debt, while margin refers to the borrowed money that the investment firm uses to invest in stocks and other financial instruments.

Advantages of Leveraged Investing

Debt gets a bad rap. When people talk about debt, they’re usually referring to bad debt like high-interest credit card debt or other types of debt that can cause enormous amounts of stress. However, leveraged investing is nothing like the debt that people rack up on credit cards.

Many investors don’t have the cash on hand to make large investments. Though they do invest their disposable income slowly over time, they oftentimes miss out on big gains simply because they don’t have enough funds to invest to see big returns.

Leveraged investing allows them to do exactly that. The concept is similar for fund managers who manage large mutual funds. However, leveraged investing allows the fund managers to simplify returns for investors on a much larger scale.

One of the best times to consider investing with leverage is when the stock market prices have dropped but they are not plummeting. By watching for these opportunities, investors can buy a large number of shares when the prices are low and see big returns when the market recovers.

Disadvantages of Leveraged Investing

While leveraged investing is beneficial because it can amplify gains, it can also do the same for losses. If an investor uses leverage in investment strategies and the investment moves in an unexpected direction, then their loss is going to be far greater than if they hadn’t ever leveraged the investment. Investors also need to be sure they can manage the leverage. This could mean that they must be able to maintain margin requirements or afford loan payments.

One of the greatest risks for leveraged investments is interest rates. Investors need to factor the cost of interest into their returns in order to determine whether the leverage is worth it or not. For example, if you are anticipating a 10% return on an investment but the interest rate is 5%, then the return on the investment is suddenly cut in half. The risk may not be worth it for a 5% return.

Leveraged investing can be a great way to grow the value of your portfolio rapidly and make larger investments to enjoy larger returns. However, it does carry a significant amount of risk. You should carefully consider your goals and the level of risk you can tolerate. You should also carefully evaluate the potential return and how it could be impacted by the interest rate for the leverage. However, if you feel particularly strong about a stock and the prices are low, then you may feel it’s worth the risk to take out leverage.