This piece is the first in a three part series on investment leverage. It is a longer learning article and as such is meant to have an impact on your day to day investing knowledge and behavior. The concept of leverage is such an important topic and one I have spent much time on in my book, The Framework Investing. In the media, the word leverage seems like it usually occurs alongside such words as dangerous, speculative, or even irresponsible, so most people have internalized the message that leverage is morally wrong; options—levered instruments that they are—are, by extension, viewed as morally wrong as well. In fact, nearly everyone uses leverage every day of their lives without incident and presumably without incurring a moral stain. In my opinion, it is not leverage that is the problem but rather an ignorance of how leverage works, coupled with overleverage and the inherent human belief that disasters only happen to someone else, that is the problem.
Leverage is a powerful tool, but like all powerful tools, if used recklessly and without understanding, it can bring its user some pretty unpleasant outcomes. Certainly a discussion of gaining and accepting exposure using option contracts would be incomplete without a good explanation of leverage.
I like to think of leverage coming in three flavors: operational, financial, and investment. This series will look specifically into investment leverage. We are going to start by first defining investment leverage and then we will discuss how it can be gained by using either debt or options, look at common ways to measure it, and introduce a unique-to-IOI method of measuring and managing leverage in an investment portfolio.
Leverage is not something to be taken lightly. Many very highly trained, well-educated, and well-capitalized investors have gone bankrupt because of their lack of appreciation for the fact that the sword of leverage cuts both ways (search for anything on a firm called Long Term Capital Management for more info here). Certainly an option investor cannot be considered an intelligent investor without having an understanding and a deep sense of respect for the simultaneous power and danger that leverage conveys.
Investment Leverage
Commit the following definition to memory:
Investment leverage is the boosting of investment returns calculated as a percentage by altering the amount of one’s own capital at risk in a single investment.
Investment leverage is inextricably linked to borrowing money—this is what I mean by the phrase “altering the amount of one’s own capital at risk.” In this way, it is very similar to financial leverage. In fact, in my mind, the difference between financial and investment leverage is that a company uses financial leverage to fund projects that will produce goods or provide services, whereas in the case of investing leverage, it is used not to produce goods or services but to amplify the effects of a speculative position.
Frequently people think of investing leverage as simply borrowing money to invest. However, as I mentioned earlier, you can invest in options for a lifetime and never explicitly borrow money in the process. I believe that the preceding definition is broad enough to handle both the case of investment leverage generated through explicit borrowing and the case of leverage generated by options.
Let’s take a look at a few example investments—unlevered, levered using debt, and levered using options.
Unlevered Investment
Let’s say that you buy a stock for exactly $50 per share, expecting that its intrinsic value is closer to $85 per share. Over the next year, the stock increases by $5, or 10 percent in value. Your unrealized percentage gain on this investment is obviously 10 percent. If instead the stock declines to $45 per share over that year, you would be sitting on an unrealized percentage loss of 10 percent.
Of course, this is very straightforward. Let’s now look at the purchase of a share of common stock using borrowed capital.
Levered Investment Using Debt
Let’s say that to buy a $50 share, you borrow $45 from a bank at an interest rate of 5 percent per year, put in $5 of your own cash, and buy that same share of stock. Again, let’s assume that the stock increases in value by $5 over one year, closing at $55 per share. At the end of the year, you sell the stock and pay back the bank loan with interest (a total of $47.25). Doing so, you realize gross proceeds of $7.75 on an original investment of $5 of your own capital, which equates to $2.75 in gross profits and implies a percentage investment return of 55 percent.
There are three important things to note by comparing the levered and unlevered examples:
- The percentage return is much higher for the levered investment (55 versus 10 percent) because you have reduced the amount of your own capital at risk much more than you have reduced the dollar return in the numerator.
- The actual dollar amount gained is lower in the levered example ($2.75 versus $10). If your investment mandate would have been “Generate at least $10 worth of investment returns,” a single unit of the levered investment would have failed to meet this mandate.
- Obviously, the underlying asset and its returns are the same in both levered and unlevered scenarios—we are changing our profit exposure to the underlying, not altering its volatility or other behavior.
To fully understand leverage’s effects, however, we should also consider the loss scenario. Again, let’s assume that we borrow $45 and spend $5 of our own money to buy the $50 per share stock. We wake the next morning to news that the company has discovered accounting irregularities in an important foreign subsidiary that has caused it to misstate revenues and profits for the last three years. The shares suddenly fall 10 percent on the news. The unrealized loss is $5—the 10 percent fall in stock value has wiped out 100 percent of our investment capital.
And herein lies the painful lesson learned by many a soul in the financial markets: leverage cuts both ways. The profits happily roll in during the good times, but the losses inexorably crash down during bad times.
Levered Investment Using Options
Discussing option-based investing leverage is much easier if we focus on the perspective of gaining exposure. Because most people are more comfortable thinking about the long side of investing, let’s look at an example of gaining upside exposure on a company.
Let’s assume we see a $50 per share stock that we believe is worth $85 (in this example, I am assuming that we only have a point estimate of the intrinsic value of the company so as to simplify the following diagram—normally, it is much more helpful to think about fair value ranges). We are willing to buy the share all the way up to a price of $68 (implying a 25 percent return if bought at $68 and sold at $85) and can get call options struck at $65 per share for only $1.50. Graphically, this prospective investment looks like this:
In two years, you are obligated to pay your counterparty $65 if you want to hold the stock, but the decision as to whether to take possession of the stock in return for payment is solely at your discretion. In essence, then, you can look at buying a call option as a conditional borrowing of funds sometime in the future. Buying the call option, you are saying, “I may want to borrow $65 two years from now. I will pay you some interest up front now, and if I decide to borrow the $65 in two years, I’ll pay you that principal then.”
In graphic terms, we can think about this transaction like this:
If the stock does indeed hit the $85 mark just at the time our option expires, we will have realized a gross profit of $20 (= $85 – $65) on an investment of $1.50, for a percentage return of 1,233 percent! Obviously, the call option works very much like a loan in terms of altering the investor’s capital at risk and boosting subsequent investment returns. However, although the leverage looks very similar, there are two important differences:
- As shown and mentioned earlier, when using an option, payment on the principal amount of $65 in this case is conditional and completely discretionary. For an option, the interest payment is made up front and is a sunk cost.
- Because repayment is discretionary in the case of an option, you do not have any financial risk over and above the prepayment of interest in the form of an option premium. Repayment of a conventional loan is mandatory, so you have a large financial risk if you cannot repay the principal at maturity in this case.
Regarding the first difference, not only is the loan conditional and discretionary, the loan also has value and can be transferred to another for a profit. What I mean is this: if the stock rises quickly, the value of that option in the open market will increase, and rather than holding the “loan” to maturity, you can simply sell it with your profits offsetting the original cost of the prepaid interest plus giving you a nice profit.
Regarding the second difference, consider this: if you are using borrowed money to invest and your stock drops heavily, the broker will make a margin call (i.e., ask you to deposit more capital into the account), and if you cannot make the margin call, the broker will liquidate the position (most brokers shoot first and ask questions later, simply closing out the position and selling other assets to cover the loss at the first sign margin requirements will not be met). If this happens, you can be 100 percent correct on your valuation long term but still fail to benefit economically because the position has been forcibly closed. In the case of options, the underlying stock can lose 20 percent in a single day, and the owner of a call option will never receive a margin call. The flip side of this benefit is that although you are not at risk of losing a position to a margin call, option ownership does not guarantee that you will receive an economic reward either.
For example, if the option mentioned in the preceding example expires in two years when the stock is trading at $64.99 and the stock has paid $2.10 in dividends over the previous two years, the option holder ends up with neither the stock nor the dividend check.
OK, now we have some common language for talking about leverage and understanding what it looks like in a series of different financial transactions. Next week, we will take a look at measuring leverage and how to begin thinking about managing it. Have questions about any of this, email us or sign up for one of IOI’s courses on options!
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