Why You Should Not Invest Using Leverage

Debt is always a negative in any form that it comes in. That is because the principal and interest have to be repaid back to the lender. Credit cards and loans are the most common forms of debt. You may not have been aware but there are even investments that rely on debt to increase their returns. Any investment vehicle that uses debt to amplify returns should be avoided by traditional investments because they can increase the risk of loss. Let’s take a look at a few ways to invest that use leverage.

Leveraged ETF

Levered ETF’s have increased in popularity over the past few years. Investors are using them to make bets against specific sectors of the economy. There are levered ETF’s for financial companies, energy companies, and basic material companies. Levered ETF’s are available for almost every area of the global economy. Many levered ETF’s seek to generate a 200% to 300% return on a daily basis. Exchange traded funds that use leverage rely on futures contracts, equity caps, collars and floors, swap agreements, forward contracts, short positions, and reverse repurchase agreements.

Traders use them to take advantage of wild swings in volatility on a day to day basis. Some investors have even brought into the idea of adding these ETF’s to their traditional portfolios. This is a bad decision because these ETF’s reset on a daily basis and can wind up costing you money even when you make a winning bet.

Margin Accounts

Margin accounts are regular brokerage accounts in which investors are allowed to use debt to increase their investment positions. Investors are loaned funds from the brokerage company so they can buy more shares than they already own. A margin account will allow an investor to put down as little as 50% of the purchase price of a specific investment and borrow the rest of an investment. Margin is great because it can amplify your gains and it is not so great because it can amplify your losses. Borrowers have to pay interest to the broker for the right to borrow this money.

In margin accounts, the holder of a financial instrument has to use a deposit to cover the credit risk of the broker. You can find yourself subject to a margin call if your account balance gets to low. This will force you to liquidate your securities and cover all of your losses out of your own pocket. Your brokerage account and your bank account could be wiped out if you are overexposed.

Futures Contract

Buying and selling futures involves speculating on the price of a commodity, currency, exchange or some physical asset.Futures contracts are derivatives since they derive their value from the price movement of an asset and not the asset itself. Buyers can either get long or short a futures contract. Long buyers expect the price of a futures contract to rise and short sellers expect the price to drop.

Futures buyers rely on margin to purchase futures contracts. They only have to put up 5 to 15% of the price of the entire commodity. This allows the futures buyer to get the maximum bang for his buck. It also can put them on the hook for big time losses if a a trading position goes against them.

Photo by: Gene Hunt

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5 Responses to “Why You Should Not Invest Using Leverage”

  1. avatar hhenderson says:

    Question 1- If I leverage with a line of credit, let’s say the line of credit is against cash. The line of credit is
    4% and the didvidend yeild is higher then 4%. I can then write off the interest from the
    the line of credit. Would this be wise or should I just use the cash and not take out a line of
    credit.
    Question 2 – Can I legaly set up a holding company with these stocks in them.

  2. avatar James Wolf says:

    Hi Mark.

    I am curious… What is your take on precious metal ETFs like SLV and GLD?

    Thanks,
    James

  3. I have never liked these exchange traded funds that use leverage. I believe that they should not even be considered exchange traded funds. They are really more like stock options. As far as buying stocks on margin this is one of the most poorly understood methods to increase your buying power when you are investing in stocks. Margin can be a very safe and cheap way to increase your buying power when you invest in stocks if it is used properly. The problem is most investors use margin in the wrong way Instead of having 90% equity and 10% debit in their margin account which is a very safe level of margin many investors load up on margin and have a ratio of 50% equity and 50% depit this is a very risky proposition.

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