How to Generate Leverage in a Portfolio
The concept of leverage involves using borrowed capital for investment and amplifying the potential returns.
While leverage can magnify profits, it also magnifies losses.
Below we focus on how you can generate leverage in your portfolio, through options, futures, borrowing, shorting, and more.
Key Takeaways – How to Generate Leverage in a Portfolio
- Leverage involves using borrowed capital to amplify potential returns, but it also magnifies losses.
- It can increase investment capacity and exposure to the market with a smaller investment.
- Options, futures, borrowing, shorting, and other techniques can be used to generate leverage in a portfolio. Each method has its own risks and benefits.
- Leverage should be approached with caution and used by experienced investors who understand the risks involved.
- Risk management, diversification, and regular portfolio review are important strategies for mitigating the potential downsides of leverage.
Understanding Leverage
At its core, leverage is about increasing your investment capacity using borrowed funds.
It can be viewed as a financial tool that allows an investor to increase their exposure to the market with a smaller investment.
Leverage also shouldn’t be thought of in a black-and-white way – e.g., “any leverage is bad, no leverage is good.”
A well-diversified, balanced, and moderately leveraged portfolio can be significantly safer than an unleveraged, concentrated one.
Using Options for Leverage
Options are a type of derivative that provides a way to achieve leverage in your portfolio in a risk-limited way.
They provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific period.
When you buy an option, you control a larger amount of the underlying asset for a fraction of its direct purchase cost.
For example, buying call options allows an investor to benefit from a rise in the underlying asset’s price with a much smaller initial outlay than buying the asset outright.
Conversely, buying put options can protect an investor from a decline in the asset’s value.
However, options can expire worthless if they are out-of-the-money at expiry, leading to a total loss of the initial investment.
Leverage through Futures
Like options, futures contracts offer another way to achieve leverage in a portfolio.
They are agreements to buy or sell an asset at a future date for a specified price.
In futures trading, the trader only needs to deposit a small fraction of the total contract value, known as the margin.
This allows for large positions to be taken with a relatively small amount of capital, effectively creating leverage.
Borrowing to Generate Leverage
Direct borrowing is another method of creating leverage.
This involves borrowing money from a brokerage to buy more securities than you could with just your available funds.
By borrowing funds, you can potentially earn a higher return due to the larger investment.
However, the risks are also magnified because if your investment doesn’t perform as expected, you still owe the borrowed money plus interest. It’s important to thoroughly understand the terms and risks of margin trading before employing this strategy.
Also note that when you borrow from brokerages, they are making a spread over government borrowing rates.
Example
If you are making a 5% yield on a leveraged investment and the margin rate is higher than that, then you would be losing money while also taking more risk.
Even if you leverage the investment 2:1 and have a 3% interest rate on the loan, you are doubling your risk to earn 7% (2*5% – 3%) instead of 5%.
Shorting as a Form of Leverage
Short selling or “shorting” is an investment strategy that involves selling a borrowed asset with the expectation that its price will decline.
When shorting you receive a cash credit, which can offset borrowing or enable for additional purposes.
However, your main risks are:
- Borrowing fees
- Potential losses can be theoretically unlimited
- Shorting comes with margin requirements, leaving less room for other trades
To offset potential losses, one strategy is to pair a short with a deep ITM put option.
For example, if SPY is at 450, a trader could short a 550 put to generate a cash credit from shorting SPY while also protecting against price rises up to 550.
That way, any price losses won’t affect you as long the price stays below the strike by expiration.
CFDs (contracts for difference)
Allow speculation on asset prices without owning the underlying asset.
Margin requirements are low, so large positions can be controlled with little upfront capital.
Note that CFDs are not available in many markets.
Other Leverage Techniques
Investing in companies that utilize leverage, either through corporate debt or by using derivatives, can also indirectly provide leverage in a portfolio.
However, these methods carry their own risks, including the potential for significant losses, and should only be used by those who understand these risks.
FAQs – How to Generate Leverage in a Portfolio
What does it mean to generate leverage in a portfolio?
Leverage in a portfolio refers to the use of various financial instruments (e.g., options, futures, swaps) or borrowed capital, such as margin, to increase the potential return of an investment.
If a portfolio is “leveraged”, it means that it includes financial derivatives or borrowed capital, amplifying both potential gains and losses.
It’s a strategy used to optimize returns, although it also increases risk.
How can I create leverage in my portfolio?
There are several ways to generate leverage in a portfolio:
- Borrowing money: This is often done through margin loans, where you borrow money from a broker to make investments. This effectively multiplies the capital you have available for investments.
- Leveraged financial products: These are financial instruments designed to amplify the returns of an underlying asset or index. Examples include options, futures, and more.
- Shorting: Shorting provides a cash credit, which can then be used to buy other securities. However, it also comes with borrowing fees, margin requirements, and price risk.
What are the risks associated with using leverage in a portfolio?
The key risk is that leverage can magnify losses as well as gains.
If your investment declines in value, you can lose more than your original investment.
Also, if you have borrowed money to make your investments, you will need to repay the loan regardless of how your investments perform.
This could potentially lead to financial distress if your assets perform poorly.
How does margin trading work in generating leverage?
Margin trading is one way to create leverage in a portfolio. It involves borrowing money from a broker to purchase securities.
The borrowed money is repaid when the securities are sold.
If the securities increase in value, the investor makes a larger profit than they would have without the use of borrowed money.
However, if the securities decrease in value, the investor may lose more than their original investment.
How can I manage the risks of leverage?
Risk management is essential when using leverage.
Here are some strategies:
- Diversification: Spreading your investments across various assets can help to mitigate the risks associated with leverage, as not all your investments will be subject to the same environmental biases.
- Stop losses: These are pre-set orders to sell an asset when it reaches a certain price. They can help limit losses in the event of a market downturn. However, markets can gap so stop losses aren’t necessarily reliable beyond day trading purposes.
- Regular portfolio review: It’s important to monitor and adjust your portfolio regularly to ensure it aligns with your investment goals and risk tolerance.
- Risk assessment: Before employing leverage, assess your risk tolerance and investment goals. Ensure you can absorb potential losses without severely affecting your overall financial situation.
- Options to reduce left-tail risk: Options can hedge against losses.
Can leverage be beneficial for all types of investors?
Leverage can potentially increase returns, which might make it attractive to all types of investors.
However, due to the high risk associated with leveraging, it’s generally more appropriate for experienced investors who have a high risk tolerance and understand the complexities of financial markets.
Leveraging should be considered based on one’s individual investment goals, risk tolerance, and investment timeline.
Conclusion
Leverage can be a powerful tool for portfolio enhancement when used carefully and with a deep understanding of the potential risks and rewards.
Whether through options, futures, borrowing, short selling, or other techniques, leverage can significantly boost potential returns.
However, the increased potential for returns comes with an increase in risk, including the possibility of severe losses.
It’s important for investors to manage and diversify their portfolio risk, be aware of their risk tolerance, and understand the instruments they’re using before applying leverage and leverage-like techniques to your portfolio.