Leverage ratios, leverage factors and margin percentage Leverage can be measured in several different ways. The first is the leverage ratio . Suppose you have $100 and want to invest $300; you will have to borrow another $200. The leverage ratio is the ratio of the borrowed amount, $200, to the cash you have, $100. So the ratio is $200:$100, which simpli fies to 2:1.
I prefer to use leverage factors . The leverage factor is your total investment, $300, divided by the cash you started with, $100. Here the leverage factor is $300 ÷ $100 = 3. The total investment is equal to your original cash plus the borrowing. For a leverage ratio of X:1 the corresponding leverage factor will be (X + 1).
A leverage factor of 1 means no borrowing and trading purely with your own cash. A leverage factor below 1 equates to using only part of your money, for example a factor of 0.5 implies that only half your cash is invested.
Many brokers quote leverage using margin percentages . This is equal to the margin as a percentage of the value of the trade. If you want to invest $300, and this requires $100 in margin, then the margin percentage is $100 ÷ $300 = 33.33%. For a margin percentage of X the leverage factor wi ll be 1 ÷ X.
In our house example, the leverage ratio is $400,000:$100,000, or 4:1. The leverage factor is $500,000:$100,000 which equals 5. The margin percentage is $100,000 ÷ $500, 000, or 20%.
Notice that the improvement in returns earned through price increase from using a mortgage (five-fold: 10% return without a mortgage, to 50% return with a mortgage) is equal to the leverage factor (5).
Who decides how much leverage you can use when you b uy a house?
The bank will set a maximum level, but you as the buyer can use less leverage if you wish. For example, if the bank allowed a leverage ratio of 4:1 you are not forced to use all of it: you can use less, but you cannot use more. If you want to buy a bigger house, you will have to stump up a lar ger deposit.
Similarly, when trading with leveraged money, the broker will set a maximum leverage ratio, or an equivalent minimum margin percentage. Depending on the product, this limit will be decided by the broker, by the regulatory authorities, or by the rules of the market you are trading in. You can use less leverage if you want, b ut not more.
What is the point of using le ss leverage?
House prices generally go up in value, and we would all prefer to live in nice big expensive houses, so why not use the maximum leverage allowed? Unfortunately, leverage is a two-way street. If I buy a $500,000 house with a $100,000 mortgage, and the price goes down by 10%, then I will lose $50,000; half my deposit.
With houses this isn’t such a big deal. Unless I need to sell up and move in the next couple of years, or switch my mortgage provider, then I can just wait for prices to go back up again.
But when we are trading with leverage in the financial world, brokers use a method called mar k to market .
Mark to market
Mark to market works as follows: each day the broker calculates the market value of everything you have in your trading account, and they compare this value to the equity in the account. They then recalculate your leverage. If the leverage ratio is too low, so that you have insufficient margin, then they will demand a margin payment to top up the account until the ratio is acceptable. This is known as a margin call . If you don’t meet a margin call, your broker will start to close out the trades in your account, a process known as auto- liquidation .
We don’t have mark to market in the housing market, but if we did then it would work like this: suppose you buy a $500,000 house with a maximum allowable leverage factor of 5. Your opening
‘housing account’ will loo k like this: House val ue: $500,000
Lo an: $400,000
Equity = House value − Loa n = $100,000
Leverage factor = House value ÷ Equity = 5
Then, say, the day after you buy your house it falls in price by 1%. Now your account appears less attractive: House val ue: $495,000
Lo an: $400,000
Equity = House value − Lo an = $95,000
Leverage factor = House value ÷ E quity = 5.21
To return the leverage factor to a value of 5, you would need to add $5,000 to the account. Your ‘housing broker’ would send you a margin call for this amount. If you met the margin call, your leverage ratio would now be acceptable: House val ue: $495,000
Cash v alue: $5,000
Total value = House Value + Cash valu e = $500,000
Lo an: $400,000
Equity = Total value – Loa n = $100,000
Leverage factor = Total value ÷ Equity = 5.0
However, if you didn’t pay the margin call then the broker would have to auto-liquidate: sell assets in your account, and use these to pay off the loan. It isn’t normally possible to sell part of a house, but let us assume that it is, and the broker sells $20,000 worth of the house (perhaps a small bathroom, or a section of the front lawn) and uses this to pay off part of the loan.
House value: $495,000 − $20,00 0 = $475,000
Loan: $400,000 − $20,00 0 = $380,000
Equity = House value − Lo an = $95,000
Leverage factor = House value ÷ Equity = 5.0
One of the dangers of auto-liquidation is that your broker isn’t concerned with getting a good price, just reducing their risk as quickly as possible. You might end up with even larger losses because your broker has just dumped your assets on the market.
What if house prices moved very quickly, by 20% or more, and you lost more than the initial $100,000 investment before the broker had collected more margin, or auto-liquidated the position?
Although house prices are unlikely to move that quickly, this is a very real possibility in the financial markets. The ‘housing
account’ will have a negative value, and in theory the broker could demand further cash to bring it b ack to zero.
In reality, what actually happens depends on the exact rules of the brokerage account and current regulatory framework. Some brokers also offer guaranteed stop losses , w hich mean you will never lose more than a certain amount on a given trade. However, these come with additional fees. Since July 2018, under new European Union rules, retail traders in certain products are protected from negative account balances. If you empty your account and still owe the broker money, then they have to write o ff the debt.
However, under current US regulations you may be on the hook to pay up further money to offset the extra losses incurred. This isn’t just a theoretical problem: whilst I was writing this book in November 2018, a US trading advisor ( optionsellers.com ) managed to lose all their customers’ money and left them liable for additi onal losses.
Mark to market makes it vital that you get your leverage ratio correct. Too high, and you will have to pay margin calls or face auto-liquidation. Too low, and you will be giving up potent ial profits.
Short-selling
So far, we have expected house prices to go up. What if we thought house prices were going to fall, rather than rise? We can use a type of trade called short selling (also known as going short , the opposite of g oing long).
Short selling is selling something that you don’t own, in the hope that it will fall in price and you can buy it b ack cheaper.
You can’t short sell houses, but if you could this is how it would work. First, you need to borrow a house from someone else, paying them a small fee for the privilege. You then sell that house to a willing buyer, and wait for house prices to fall.
Assuming that prices do fall, you can then buy the house back more cheaply. You then return the house to its original owner, keeping the profits f or yourself.
With a mortgage purchase you borrow money to buy a house, but when short selling you borrow a house and sell it in exchange for money. You also have to worry about the cost of carry. For a mortgaged purchase this is the difference between the rental income, and the cost of financing your purchase. However, for short selling the payments are different. Instead of paying interest to borrow money,
you will pay a borrowing fee to borrow the house. In theory, you will also earn interest on the money you generate by short selling. Instead of being paid rent, you will have to pay rent to the original owner of the house.
If buying an asset is a positive carry trade, then selling short will be a negative carry trade. If you earn $4,000 a year from going long a house (the net of rent and mortgage payments), then logically you will have to pay $4,000 to go short. However, you won’t normally pay exactly the same carry that you would earn from being long. Banks pay lower interest rates on deposits than they charge for mortgages. Instead of earning interest at the mortgage rate of 4%, you will probably be earning much less, perhaps only 2%. The difference is a financing spread and is a source of revenue for the bank. Similarly brokers also earn a financing spread on the different rates they charge for long and short ma rgin trades.
Here is a detailed example of a (theoretical) short sale in housing:
Example: Theoretical House Short Sale on margin This is difficult to do with houses as people don’t like lending them out for other people to temporarily sell, and you will struggle to find someone willing to sell their house at a loss a year after buying it from you. But it is common practice in financi al markets.
T hree key characteristics of leveraged products Leveraged products differ from each other in the fol lowing ways: They are either physical products or derivatives.
Derivative products can be dated or undated.
Products can be traded on exchange or over the co unter (OTC).
1. Physical vs derivative
It could be possible to bet on the price of housing going up or down without actually buying or short selling, if you could find someone to take the other side of the bet. If you went long, and prices went up, then you would make a profit. However, if prices fell then you would lose. Either way, the loser of the bet would then pay the winner.
Similarly, financial traders can use derivatives to bet on market prices. A derivative is a type of financial product that you can use to benefit from price changes without actually owning the asset. It will pay you what you would have earned from buying on margin (if going long the derivative), or selling short (if g oing short).
The returns on a derivative bet have to be equivalent to those of the physical asset, or it would be possible to buy an asset whilst placing a short bet against it, and be guaranteed to make a fixed profit or loss irrespective of price movements (which would be called an arbitrage trade). Hence, you will also earn
any positive carry or pay negative carry that you would have earned or paid on the under lying asset.
Incidentally, non-derivative products are often called ‘cash’,
‘spot’ or ‘physical’ to distinguish them from derivatives.
1. Dated vs undated
Derivatives come in two variations: dated and undated . An undated derivative works like a normal margin trade. You put the trade on and can hold it for as long as you like. There is no specific date that you have to close the trade before. But a dated derivative is for a specific date, known as the expiry date.
A dated derivative for houses would work like this: you could go long and bet that the price of your $500,000 house will be higher in one year. If it was currently January 2020, then the expiry date of the trade would be Ja nuary 2021.
You also receive any positive carry or pay negative carry when you make a dated bet. Unlike undated bets the carry isn’t paid to you over the life of the trade, but it is embedded within the price of the derivative.
So, for example, if buying a house is going to earn $4,000 in carry over the next year, then the dated bet price would include a $4,000 discount on the $500,000 spot price: $496,000. If nothing happens to house prices, and the underlying house still costs $500,000, then a long bet would make $4,000 in profits by the end of the year. Conversely if you had gone short, then you would have lost $4,000 as the dated price rose from $496,000 to $500,000; equivalent to the negative carry of a sho rt position.
Notice that there is no financing spread for dated derivatives: the negative carry when short is identical to the positive carry when long. Because the carry is embedded in the price it has to be the same for both long and sh ort traders.
You do not have to hold a dated derivative until the expiry date.
The position can be closed at any time before the expiry. But if you want to keep a position open when expiry is looming, you can close your trade in the expiry date you are holding, and simultaneously open the same trade in the next expiry date. This is known as rolling your trades.
1. Exchange vs OTC
Brokers act as intermediaries between you and the market. But what is ‘the market’? There are two types of financial market, exchanges and over-the-coun ter trading.
An exchange is a formal venue for trading, where you can’t trade on an exchange without being a member. Brokers are either members
of the exchange or will send your orders to member firms.
Exchanges used to be based in physical locations, where people in colorful jackets made weird hand signals at each other, but now the vast majority of trading is done electronically. Futures and shares are traded o n exchanges.
Over the counter (OTC) trading is done outside of exchanges, over electronic links between large banks and brokers, and between brokers and their customers. When trading spread bets, FX and CFDs, your contractual relationship is with the broker and your order is not sent onwards ¹² to an exchange. These are all types of OTC trading. I will discuss the pros and cons of exchange and OTC trading more in chapter two.
What products are there for leveraged trading, and how do they work?
In this section we will be looking at specific examples of leverag ed products:
Buying stoc ks on margin
Short se lling stocks
Exchange traded funds (ETFs)
Foreign e xchange (FX)
Contracts for diffe rence (CFDs)
Spread bets
Futures
Dated CFD and spread bets
1. Buying stocks on margin
The first type of leveraged product we’ll consider is buying stock on margin . This is equivalent to buying a house with a mortgage. This is straightforward to do with stocks if your broker lets you have a marg in account .
Imagine that we want to invest $6,000 in Citigroup shares, but only have $3,000. We can borrow the other $3,000 for a leverage factor ¹³ of $6,000 ÷ $3000 = 2.
Sadly, the broker is not lending $3,000 as a charitable gesture.
They will charge a premium interest rate for the privilege.
Interest rates are set relative to a reference rate like the London Interbank Offered Rate (LIBOR), with an additional funding spread . Brokers charge a higher interest rate on any borrowing by adding a spread and pay a lower interest rate on deposits 20
after deductin g a spread. ¹74
When buying stock, my broker currently charges an interest rate which is equal to USD LIBOR, plus a funding spread, for a total of 3.2% a year. Brokers also make money by charging commission (a fee for each trade that you do), or a trading spread (you pay a higher price when buying, and receive less for a sale), and som etimes both.
As an example of how trading spreads work, suppose that a broker will charge $71.25 if we want to sell Citigroup and $71.30 if we want to buy. The rate the broker will buy at (and we sell: $71.25) is the bid , and the rate they will sell at (and we buy: $71.30) is the offer. The spread is $71.30 − $71.25 = $0.0 5 per share.
An example of a stock margin purchase can be seen below.
As when buying a house, our profits are magnified by leverage.
The share price went up by around 5% but we made 10% in profits.
Profits have doubled as expected from our leverage ratio of 2
(the negative carry of $8.10 is negligible in this case). Of course, if we had made a loss that would also b e magnified.
We usually receive dividends on stocks, which are a
nalogous to the rent received by a housing investor. Dividends are a regular payment made by most companies to their shareholders and are usually paid quarterly or every six months. In the one-month period in the example we didn’t get a divid end payment.
Example: Buying stock on margin
Buying stock on margin also differs from buying a mortgaged house in one crucial respect. If house prices fall substantially, I will have a loan that is larger than my house is worth. But as long as I keep paying my mortgage the bank won’t care until I come to sell or remortgage.
But this isn’t true when you buy stock on margin: we have to worry about mark to market. If the price of Citigroup stock started to fall, then our broker would be on the phone screaming 20
for more cash to cover the losses. ¹76 If I didn’t co-operate with my broker’s demands then my Citigroup stock would get auto-liquidated. Remember: auto-liquidation is bad and to be avoided a t all costs.
Incidentally, you may be wondering why we bother working out small amounts of money like the $2 in commissions and $8.10 in negative carry in the above example. The total of these costs works out to about 0.34% of our initial $3,000 cash investment.
Even if I include the effect of paying the trading spread, the cost of the trade is still less than 0.5%. This pales in insignificance to our 10% profit.
However, as we shall see in later chapters, trading costs are actually extremely important because, unlike our profits, they
are guaranteed. We pay them on every trade regardless of its profitability. If we don’t have an accurate idea of what our costs are, then we can’t know how many trades we can afford to do without paying too much to our brokers. All successful traders have an excellent grasp of what their trading costs are, and you should emulate them by not ignoring the odd few quid or dolla rs in costs.
Margin accounts are relatively common in the US, but harder to fin d in the UK.
Margin buying is a physical trade where we buy the underlying asset with the help of leverage.
Stocks are listed on exchanges like the New York Stock Exchange (NYSE) and the London Stock Exch ange (LSE).
Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Page 3