Leveraging can be a risky game to play. Yet, if used correctly and with prudence, it can also help us reap better returns on our investments. For example, leveraged positions on an exchange-traded fund (ETF) by a factor of 2 can double our investment return. If the ETF returns 10% this year, our total return due to leverage will be 20%. This can, therefore, be very appealing to investors who are looking to make their money work harder for them. Having said that, the opposite is also possible. If the ETF falls by 10% this year, the leveraged investor would…
Leveraging can be a risky game to play. Yet, if used correctly and with prudence, it can also help us reap better returns on our investments.
For example, leveraged positions on an exchange-traded fund (ETF) by a factor of 2 can double our investment return. If the ETF returns 10% this year, our total return due to leverage will be 20%. This can, therefore, be very appealing to investors who are looking to make their money work harder for them.
Having said that, the opposite is also possible.
If the ETF falls by 10% this year, the leveraged investor would instead make losses amounting to 20% of his capital. If for some reason, the ETF falls too much, the investor will face a margin call, which means he needs to top up his account to hold his position. Consequently, investors who leverage may not have the flexibility to see out major down cycles. There are also additional costs involved with leveraging that can negatively affect the investor further.
Therefore, investors who are looking to leverage need to be very careful not to over-leverage and to ensure that their leveraged investment is not too volatile.
With this warning out of the way, here are three common ways that investors can leverage their investments.
Using margin investing
Some trading platforms allow the investor to use margin to invest in stocks. This means that an investor can borrow an amount of money to buy more stocks than they have the capital for.
Typically, most trading platforms allow an investor to borrow 50% of the value of the stocks that are to be purchased. That means for an investor with a $10,000 capital, he can buy $20,000 worth of stocks.
The main downside of this method of leveraging is the interest rate that is charged for the loan. To reap a profit, the investor’s stock return must first exceed the loan interest rate, which can sometimes be as high as 8%.
There are many forms of derivatives available for investors. Some of them can help an investor hedge an investment, while others are used to leverage. Probably the most common derivative that investors use to leverage is the stock option.
When buying a stock option, an investor is buying the right to purchase or sell a stock at a predetermined price known as the strike price.
For call options, an investor will benefit if the price goes above the strike price. Options are typically cheaper than the underlying stock and investors can buy more options using their capital than they can for actual stocks. This makes it a useful tool for investors who are looking to leverage.
Having said that, short-term option contracts are usually inadvisable for the long-term investor. This is because the short-term volatility of a stock makes it difficult to predict. If the stock does not reach the strike price, the option will expire worthless, and the investor would have lost all the money he invested in the option.
Leveraged ETFs are funds that use leverage to increase an investor’s return. Instead of merely investing in a stock index, the leveraged ETF will buy two or three times more than their capital. This means gains and losses are multiplied.
Asia has seen a significant influx of funds moving into leveraged ETFs recently as some investors look to increase their investment returns.
However, the major downside for this sort of investment is that these funds typically charge a much larger management fee than the typical ETFs.
The Foolish takeaway
There are many ways that an investor can use leverage to try to increase his investment returns. However, before putting their hard-earned money into such leveraged instruments, investors have to be aware of the immense risks that leveraging can have.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.