Some traders and investors want to use leverage in their portfolio. On the surface, it seems like this is pointless. Leverage magnifies your gains and your losses, so theoretically there should be no difference between you using and not using leverage.
But this isn’t entirely true. If you can protect your downside with stop losses and let your winners run, leverage will allow you to magnify your returns while keeping your losses under control.
There are 3 types of common financial products that have leverage:
- Futures
- Options
- Leveraged ETFs.
Here’s why leveraged ETFs are the best out of these 3 leveraged investment and trading vehicles.
The problem with futures
For those who aren’t aware, a futures contract is the legal agreement (the right and the requirement) to buy or a sell a commodities or underlying market at a predetermined price in the future.
All futures contracts have leverage. When you buy or sell a futures contract, you are essentially putting down a deposit that is a low percentage of the total value of the assets in the futures contract. This is similar to paying for a downpayment on a house. This small deposit means that your position is leveraged – the market’s movements will magnify your portfolio’s returns.
This deposit is called the “initial margin”, which is usually 5-10% of the value of the futures contract. If the initial margin is 10% of the contract, you are essentially leveraged 10-1.
The problem with this is that if the market moves against you, your entire position might be wiped out. For example, if you are long and the market falls 15%, a futures position with 10% margin will be wiped out if you can’t raise the additional cash to meet that “margin call”.
This means that with futures contracts, you cannot hold your position until you are right.
Nobody can always get the timing of a trade or investment perfectly. Sometimes you will be too early, which means that the market will temporarily move against your position.
If the market moves against your position and you face a margin call, your position could be wiped out. It doesn’t matter if your market outlook was ultimately correct and the market rebounded in your favor. In the meantime, you lost everything and you couldn’t hold your position until you were right.
Related: Leveraged Inflation Fighters in Real Estate
The problem with options
Options give you the right, but not the obligation, to buy a security in the future at a predetermined price. You must pay a “premium” to buy this right (the options contract).
For example, let’s assume stock XYZ is at $100. You buy call options for a $3 premium. If the market rises $10, you just made 233% on your position. Hence you can see how options inherently use leverage. A person who bought stock XYZ outright would have made 10%. The options trader made 233%.