Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated inte𒈔rest. Leveraged investing exposes an investor to higher risk.

Borrowed capital can come from any source. In this article, we compare three common sources: a brokerage margin loan, a futures product (such as an equity index or a 澳洲幸运5官方开奖结果体彩网:single stock future), and a 澳洲幸运5官方开奖结果体彩网:call option. Virtually any investor with a brokerage account can access these. Understanding the alternatives is the first stepꦦ to building the right leveraged investment, so read on to learn more about how to d💟etermine what kind of leverage to use in your portfolio.

Margin Loans

Margin loans use the equity in an investor's account as 澳洲幸运5官方开奖结果体彩网:collateral for the debt. They are provided by brokers and are heavily regulated by the Federal Reserve and other agencies, as the too-easy extension of credit to investors was one of the factors that contributed to the 1929 stock market crash.

The 澳洲幸运5官方开奖结果体彩网:initial margin and 澳洲幸运5官方开奖结果体彩网:maintenance margin serve as a cap on the amount that can be borrowed. A 50% initial maintenance margin requirement results in a maximum initial leverage ratio of 2 to 1, or $2 of assets for every $1 of equity. Of course, an investor who consistently uses the maximum margin available 澳洲幸运5官方开奖结果体彩网:faces an increased risk of a margin call in a market decline.

The minimums for both the initial and maintenance margins are set by the 澳洲幸运5官方开奖𓂃结果体彩网:Securities and Exchange Commission (SE🎀C). However, some brokers do provide customers with a way to bypass these minimums by providing certain accounts with 澳洲幸运5官方开奖结果体彩网:portfolio margins. In these accounts, the margin is based on the largest potential loss of the portfolio, as calculated by the underlying prices and volatilities. This may result in lower margin requirements, especially if hedging is used.

Costs

Interest rates on margin loans may fluctuate and are usually tiered based on the amount borrowed. One thing to note is that they tend to be lower than other credit products, such as credit cards.

For example, a large online broker may charge 7.24% on margin balances above $1 million, but 10.24% on balances below $50,000. Some online brokerages pro🎉vide a less expensive margin and use it as a selling point.

Advantages and Disadvantages

• Advantages: Margin loans are easy to use and the capital can be used to purchase virtually any investment. So an investor with 100 shares of Coca-Cola (KO) could borrow against those shares and use the proceeds to buy 澳洲幸运5官方开奖结果体彩网:put options on another security. 澳洲幸运5官方开奖结果体彩网:Dividends from these shares could then be used to help pay the margin interest.
• Disadvantages: An investor who uses margin can face significant 澳洲幸运5官方开奖结果体彩网:financial risk. If the equity in the account falls below a predetermined level, the broker will ask the investor to contribute additional capital or 澳洲幸运5官方开奖结果体彩网:liquidate the investment position.

Stock and Index Futures

A 澳洲幸运5官方开奖结果体彩网:futures contract is a 澳洲幸运5官方开奖结果体彩网:financial instrument used to purchase a specific investment for a certain♑ price at a later date. Financing costs are included in♍ the price of the future, which makes the transaction equivalent to a short-term loan.

Futures are often associated with currencies, commodities, and interest-earning instruments, rather than equities. However, stocks have been coming on strong in recent years, with equity derivatives accounting for almost 62% of all derivatives contracts in 2021. More than 39 billion equity derivatives contracts were traded in 2021, which was a 10-year record.

Global futures and options trading increased by 64% in 2023 from the previous year, reaching a total of 137.3 billion contracts. Growth was boosted by a rise in trading in India. North America had the second-largest trading volume for futures and options with 17.9 billion contracts. That's a jump of 6.2% from the previous year.

Futures and options on equity indices, the largest category of the listed derivatives markets in terms of volume, reached 99.9 billion contracts in 2023, an increase of 105% from the previous year. Single-stock futures and options, though, dropped by 4.8% to 12.6 billion contracts.

Costs

Although these products have a reputation for being beyond the reach of the typical 澳洲幸运5官方开奖结果体彩网:retail investor, companies are 𒐪moving🥃 quickly to expand access. More online brokerages now provide access to futures, and less initial capital is now required to trade them.

Investment selection is also limited but growing. Futures contracts can be purchased on well-known indexes, such as the S&P 500 or Russell 2000, on some 澳洲幸运5官方开奖结果体彩网:exchange-traded funds (ETFs), such as the SPDR Dow Jones ETF (DIA), and now on more than 400 individual stocks. Futures contracts on stocks are known as 澳洲幸运5官方开奖结果体彩网:single-stock futures (SSF).

Investors are required to maintain a 澳洲幸运5官方开奖结果体彩网:cash position to purchase a future. This is often referred to as margin but is a 澳洲幸运5官方开奖结果体彩网:performance bond. This performance bond is equal to some percentage of the underlying, typically 5% for broad indexes and up to 20% for single stock futures. This p🌳rovides leverage from 5 to 1, to 20 to 1.

Advantages and Disadvantages

• Advantages: Their relatively low 澳洲幸运5官方开奖结果体彩网:bid-ask spreads and high amount of leverage make futures contracts popular with investors. Interest costs are also much lower than margin rates—they are calculated as the broker call rate minus the 澳洲幸运5官方开奖结果体彩网:dividend yield paid by the underlying securities.
• Disadvantages: If the price of the 澳洲幸运5官方开奖结果体彩网:underlying security declines, the investor will have to put up more cash to maintain his or her position. This is similar in practice to a 澳洲幸运5官方开奖结果体彩网:margin call. This can make futures very risky. To prevent catastrophic losses, futures are often hedged with options.

Stock and ETF Options

Options provide a buyer with the right to buy or sell shares of a security for a specific price. Each option has a strike price and 澳洲幸运5官方开奖结果体彩网:expiration date.

Costs

Call options, or options to buy, have a built-in financing cost similar to futures. However, option pricing is primarily driven by seller risk, which is related to the volatility of the underlying ꦜinvestment.

Options expire but can be 澳洲幸运5官方开奖结果体彩网:rolled over to new expiration dates by selling the existing option and purchasing a new one. This can be costly, depending on the bid-ask spreads of the two options. It also results in the investor trading a higher delta option for a lower delta option.

Advantages and Disadvantages

• Advantages: Options play an important role in the market as hedging tools. The potential 澳洲幸运5官方开奖结果体彩网:downside risk in a futures contract is very large, often many times the initial investment. Using options can limit this risk, at the expense of some of the potential appreciation. Furthermore, options are available for most large stocks and many ETFs.
• Disadvantages: 澳洲幸运5官方开奖结果体彩网:Index options are more specialized and are not available at most brokers. There may be dozens or even hundreds of options available for a specific security, and selecting the appropriate one can be difficult. Part of the challenge is the tradeoff between the initial premium, the leverage provided, and the rate of time decay. 澳洲幸运5官方开奖结果体彩网:At-the-money and 澳洲幸运5官方开奖结果体彩网:out-of-the-money call options with closer expiration dates have the highest amount of leverage but can lose value rapidly as time passes. The relative complexity of this can be discouraging for new investors.

Comparing Leveraged Instruments

Although futures products are still not available to many retail investors and futures contracts are not available on all products, access to these products will likely continue to increase. Futures provide investors with higher leverage at lower interest rates than margin loans, resulting in greater capital 澳洲幸运5官方开奖结果体彩网:efficiency and higher profit potential.

However, some brokers have taken step🥃s to make margin loans more competitive 🌳with futures products. These brokers are charging lower interest rates and are either lowering interest rates to the SEC minimums or introducing portfolio margins to bypass them altogether. Margin loans also allow a much broader selection of investments than futures.

Both margin loans aꦆnd futures c⛄ontracts leave investors exposed to considerable downside risk. Declines in the underlying security can lead to large percentage losses and may require the investor to immediately provide additional funds or risk being sold out of their position at a loss.

Call options combine the leverage and interest rates of futures with hedging to limit downside risk. Hedging can be costly but can lead to higher overaꦗll returns, as it allows an investor to invest more capital rather than holding a reserve for catastrophic losses.

The Bottom Line

There are many tools available to leveraged investors and the selection is growing. As always, the challenge🔥 is knowing when and how to use each one.💝