The average return on investment from the S&P 500 is 10% averaged out over the years. However, an investment portfolio that follows the S&P 500 may gain twenty percent or more some years and lose nearly as much in other years. Patience is the key to investing in stocks successfully over the long term, and knowing how to access intrinsic stock value. However, many investors would like to make more money faster than the 10% average and are willing to leverage their investments in the process. Here are a few thoughts about investment leverage risks.
What Does It Mean to Leverage an Investment?
In the case of the stock market, leverage is when investors use various strategies to increase their buying power. All of these tend to add risk to their investing. Shorting a stock is one way to leverage an investment. The trader borrows the stock for which they pay interest and then sell it. They are betting that the price of the stock will fall in which case they will buy it at the now-lower price, return the shares that they borrowed, and pocket a profit. Unfortunately, stocks do not always fall in price and if the price goes up they get caught in a short squeeze and have to buy the stock for more thus losing money. We wrote about the Tesla short squeeze and the same thing happened with Gamestop.
What Is Synthetic Stock?
A way that options traders reduce their cost of a “long” stock position is by creating “synthetic stock.” What the trader does is buy at-the-money calls on a stock that they believe will rise in price. At the same time they sell at-the-money puts on the same stock for the same strike price and same expiration date. The money earned by selling the puts covers the cost of buying the calls so the trader is in a situation similar to owning the stock (or simply buying calls) but without having had to buy the stock or pay the entire price of the calls. When the stock goes up the trader can then buy the stock at the strike price and own it at the currently higher market price or simply exit the trade with a profit. The problem is that if the stock price collapses there is essentially no bottom to their losses.
The Taiwan Stock Market Example
The issue of investing with borrowed money or leverage investing came to mind after the recent correction in the Taiwan stock market as noted by Bloomberg.
Taiwan stocks sank for a third day in volatile trading, extending a rout that’s triggered the fastest liquidation of leveraged positions since 2018. Forced selling has compounded this week’s losses, with the level of margin debt falling by a net NT$12.9 billion ($461 million) on Wednesday, according to exchange data compiled by Bloomberg.
The correction started because Taiwan is having another surge of Covid-19 but was made a lot worse by the amount of leverage in their stock market.
Investing with Borrowed Money
There have been reports of people putting second mortgages on their homes in order to invest using the Robinhood app. The app has addictive aspects and thus can be dangerous for naïve traders. Investing with borrowed money in such situations only makes it worse. A problem when you lost 50% on an investment is that that you cannot get your money back by making 50% the next time around. Rather you need to double your investment in order to recoup your losses.
Taking On Risk to Leverage Your Investment
Synthetic stock is an example of adding risk in order to leverage an investment. The trade works wonderfully well so long as the stock goes up in price. It becomes an unmitigated disaster if the stock falls precipitously. Those who successfully use this approach watch their trades carefully and are skillful at picking the stocks on which to apply this strategy. The same applies even more to the investment leverage risks of using borrowed money.
Investment Leverage Risks – Slideshare Version
Investment Leverage Risks – DOC