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.
And the complex nature of options, along with their time sensitivity (expiration dates), requires a nuanced understanding of the market.
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.
Traders nonetheless need to watch out for implied costs, such as contango, that can effectively be like paying interest.
Borrowing to Generate Leverage
Direct borrowing is another method of creating leverage.
This involves borrowing money from a brokerage (margin account) 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/trading 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 and its own interest costs on the trade itself (independent of borrowing fees), 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 aren’t 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.
But these methods carry their own risks and should only be used by those who understand these risks.
We’ll cover these more below.
How Do Hedge Funds, Banks & Institutions Borrow Cheaply and Leverage Their Trades?
Institutions, such as banks, hedge funds, and proprietary trading firms, have several ways to leverage their trading strategies without paying significant interest or other costs.
Here are some common methods:
Using Repo Financing
Institutions can engage in repurchase agreements (repos) to effectively borrow funds at low rates.
In a repo transaction, the institution sells securities (e.g., Treasuries) to a counterparty and agrees to buy them back at a slightly higher price in the future.
The price difference represents the implied borrowing rate, which is typically lower than traditional lending rates.
Accessing Credit Lines and Prime Brokerage
Large institutions often have access to low-cost credit lines and prime brokerage arrangements with investment banks.
These facilities allow them to borrow securities or cash at preferential rates, enabling leveraged trading strategies.
Using Derivatives
Institutions can use derivatives, such as options, futures contracts or swaps, to gain leveraged exposure to different asset classes without directly borrowing funds.
The leverage is built into the derivative instrument itself, and the institution only needs to post initial margin requirements.
Exploiting Regulatory Arbitrage
Some institutions may engage in regulatory arbitrage by structuring their trading strategies in a way that minimizes capital requirements or other costs.
For example, they may use off-balance-sheet vehicles or engage in netting of positions to reduce their overall capital charges.
Internal Funding and Netting
Within large institutions, different trading desks or divisions may internally fund each other.
This means they can effectively provide leverage without external borrowing costs.
Additionally, institutions can net offsetting positions across different desks, reducing their overall capital requirements and funding needs.
For example, if one trading desk is long 100,000 shares of a stock and another is short 70,000 shares of the same stock, their funding needs net to 30,000 shares overall.
Collateral Transformation
Institutions with access to diverse asset classes can engage in collateral transformation.
This is where they temporarily swap lower-quality collateral (e.g., stocks, corporate credit) for higher-quality collateral (e.g., Treasuries).
This allows them to use the higher-quality collateral for leveraged trading or financing operations.
Securities Lending
Institutions with large securities portfolios can lend out some of their securities to other market participants in exchange for a lending fee.
This generates additional income that can effectively offset some of the costs associated with leveraged trading strategies (or wherever else in the business).
Rehypothecation
When institutions receive cash or securities as collateral from counterparties, they may have the ability to reuse or “rehypothecate” that collateral for their own purposes, such as funding leveraged trades.
This allows them to effectively multiply the use of their capital without directly borrowing or paying interest.
Portfolio Margining
For institutions engaged in multiple asset classes or trading strategies, they can take advantage of portfolio margining.
This approach allows the institution to cross-margin their positions, and potentially reduce the overall margin requirements compared to margining each position individually.
Lower margin requirements translate to less capital tied up, which enables more leverage.
Synthetic Financing
Institutions can use derivatives, such as total return swaps or equity-linked notes, to synthetically replicate the exposure of a leveraged position without directly borrowing funds or securities.
This can sometimes be more cost-effective than traditional financing methods.
Things to Know
Not Truly “Free”
Some of these don’t involve explicit interest payments, but they carry implicit costs:
- Opportunity costs of assets tied up as collateral for margin.
- Fees associated with swaps or derivatives transactions.
- Implied leverage in the contract being traded (e.g., contango in future contracts, net premium outlay in options contracts).
Risk
Leverage inherently increases risk.
Derivatives and other structured transactions can be complex with the potential for large losses if markets move against them.
Institutions need to prudently manage their counterparty risk, liquidity risk, and overall leverage levels for financial stability and compliance with regulatory requirements.
Counterparty Risk
These strategies often involve relying on other institutions as counterparties, which exposes them to potential default risk.
How Do Banks Leverage Themselves So High?
Banks can achieve very high leverage ratios, sometimes 15x or higher, through a combination of regulatory capital requirements, fractional reserve banking, and off-balance sheet activities.
Here are some of the key ways banks leverage themselves to such high levels:
Regulatory Capital Requirements
Banks are required to maintain a certain level of capital based on the riskiness of their assets, as determined by regulatory bodies like the Basel Committee on Banking Supervision.
Typical capital requirements range from 4-10% of risk-weighted assets.
This means banks can leverage their capital up to 25x for lower-risk assets.
Fractional Reserve Banking
Banks only need to hold a fraction of customer deposits as reserves, with the rest being used for lending and investing purposes.
This allows banks to multiply their leverage by essentially borrowing from depositors at a very low cost.
Off-Balance Sheet Activities
Banks engage in various off-balance sheet activities, such as securitization, derivatives, and loan commitments, which provide exposure and leverage without directly affecting their on-balance sheet assets and capital requirements.
Repo Financing
As mentioned in the previous section, banks can use repurchase agreements (repos) to effectively borrow funds at low rates by temporarily selling securities and agreeing to buy them back later.
This provides leverage without directly affecting capital ratios.
Accounting Treatment
Certain accounting rules allow banks to classify some assets and liabilities in ways that reduce their impact on regulatory capital calculations, enabling higher leverage.
Internal Risk Models
Banks often use their internal risk models, approved by regulators, to calculate capital requirements.
These models can sometimes underestimate risk, and allow banks to hold less capital and operate with higher leverage.
Post-2008 Regulation
Regulatory bodies have implemented measures to limit excessive leverage in the banking system following the 2008 financial crisis.
Nonetheless, banks continue to find ways to operate with significant leverage within the regulatory framework.
Risk Management & Considerations
Understand the Magnified Risk
Leveraging augments both gains and losses.
A small market movement in the wrong direction can lead to significant losses, possibly exceeding the initial investment.
Be Mindful of Costs
Interest on borrowed funds and transaction costs and fees associated with certain financial instruments (like shorting a stock) can erode returns.
For instance, with shorting a stock you might have interest accrue on the amount borrowed itself – independent of the borrowing fee.
Know Your Risk Tolerance
Leverage is typically more suited for traders who are risk-tolerant and well-versed in market dynamics.
It’s imperative to assess whether leverage aligns with your goals and risk appetite.
Continuous Monitoring & Management
Leveraged positions require active and continuous management, given their susceptibility to market volatility and potential for rapid losses.
Consult Financial Experts
Before engaging in leveraged investments, it’s advisable to consult with a financial advisor to understand the implications fully and make sure that the strategy aligns with your overall objectives.
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 using leverage, look at your risk tolerance and investment goals. Make sure 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.