Leveraging – Not A Good Idea Always

Soham has been investing small amounts in the stock market for some time.  He had made good profits on some of the stocks invested at the beginning of the year 2018. He decided to increase his stake as he wanted to make more profits. But he did not have enough capital and so he borrowed Rs. 5,00,000 and invested in Indiabulls Housing Finance futures in June 2018. He bought 10 lots (500units – 1 lot)) of Indiabulls Housing Finance futures. His contract value was Rs. 6,00,000. Each unit cost Rs. 1200. Futures have a maximum of three-month duration but you can execute them anytime. In July and August 2018, the price was in the range of Rs. 1115 and Rs. 1,381. He decided to retain them. In September 2018, the price was on a downward trend. He held on hoping there will be a reversal. Finally, he had to square off at Rs. 863.95. The sale value was around Rs. 4,31,9750. He made a loss of Rs. 3,71,9750! Apart from that, he had to incur the cost of the transaction and the interest payable on the borrowed sum. He leveraged money to invest and lost a huge sum.

Soham’s example yet again proves the legendary investor Warren Buffet’s quote  “It is crazy in my view to borrow money on securities.

Leverage means to use borrowed capital for making investments in such a way that the returns from the investment justify the interest payment. It is a strategy used by investors and traders. This concept is used by brokerages too when they allow you to purchase stocks on margin.  A margin means the brokerage firm allows you to purchase more stocks than you can afford on the creation of a margin account with the brokerage.

In case of leveraging, you can take a bank loan or a personal loan or invest through futures and options on the exchange. In the case of margin trading, you will have to activate the margin trading option. The brokerage will provide funds for a pre-decided proportion. The margin account should have minimum cash or securities that can be squared off to pay off the borrowed amount else the brokerage firm will square off trades or sell securities to make up for the margin maintenance.

Leveraging has some advantages –

  • It helps traders and investors to invest in more assets and get more returns. For example, if you had bought 40 shares of L&T in August 2018 at Rs. 1300 and sold in November 2018 at Rs. 1360, you would have made a profit of Rs. 2400. On the other hand, if you had borrowed (purchased on margin) and purchased 100 shares of L&T, you would have made Rs. 6000 as profit which is more than double. You would have made higher profits and maintained the margin as well.
  • If your investments/ trades are successful, you make money with a small corpus which would not have been possible otherwise.
  • It provides flexibility. For example, you want to buy a certain stock but do not have enough money and it is not the right time to sell any other stock, you can leverage or use margin trading to buy the stocks and then close the margin immediately.

But margin trading or stock market investment using leveraging is riskier than the usual buy and sell off stocks. In case of loss, you not only lose your capital, but you will need to pay back the principal amount and the interest applicable. In the example of L&T, if the shares had fallen to Rs. 1200, you would have made a loss of Rs. 10,000 and your margin account would have to be compensated.

It is not a good idea to use leverage or margin trading in the following scenarios –

  • Markets are volatile like in recent times. Even good stocks can get hammered which can lead to big losses.
  • You are a novice to investment or have a low-risk tolerance capacity, you should avoid investing in leverage.
  • You will have to pay interest or the margin received in most cases. So your returns should justify the interest paid.
  • Margin trading is not a good idea for long-term investing as stock markets are risky and your losses can get compounded when your investment value falls. You make capital losses and have to pay interest.

Leveraging and margin trading are high-risk strategies. Who should go for leveraging? Go for it only if you are sure that you will make good profits and that the market will be on your side. Go for it only if you are a seasoned investor and can take losses in your stride. If you are a professional investor who understands the market and will be able to manage your losses with other investment strategies and tactics, you can try it out.

Do remember the following when you leverage –

  • Maintain a stop loss. If you reach that point, exit from your position. It is important to cut losses.
  • Decide on the maximum exposure that you can take from a risk point of view.
  • It will be difficult to time the market every time. Understand and analyse the market conditions and the stock/index position before leveraging to invest.
  • If you must leverage, ensure that the sum invested is a small part of your investment portfolio so that the loss can be absorbed in the long run.

 

Key Takeaways

  • People invest in the stock market using borrowed funds – This is leveraging.
  • Leveraging is not a good idea when markets are volatile.
  • Unless you are a seasoned investor with a high risk tolerance, it is better to stay away from investing via leverage.

 

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