Leverage Investing: What It Is And How It Works
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Investors can generate returns on their capital by investing in different asset classes like stocks and real estate. While getting good returns is possible, you can increase your total gains with leverage investing. This type of investing gives you more capital that you can deploy into various assets. It increases your purchasing power and lets you build your stock positions faster.
While leverage investing presents a significant upside if things go well, it can also lead to financial ruin if used improperly. This guide will cover how leverage investing works and some things to keep in mind before considering this path.
In this article
What is leverage investing?
Leverage investing is when you use debt to buy more assets than your cash position allows. For instance, if you have $10,000 ready to invest, you can buy 50 shares of a company valued at $200/share.
It’s a good start if you like the company, but retail investors may prefer to own 100 shares immediately. A margin account can give investors the extra capital to cover the purchase, so they can end up with 100 shares instead of 50.
Real estate investors and aspiring homeowners usually rely on leverage to acquire properties. After putting some of their own money down, the bank covers the rest of the purchase with a mortgage. They then have to make monthly payments toward the mortgage until they fully pay it off.
Buying a property with an all-cash purchase is possible instead of relying on the bank.
However, most people do not have enough money in their savings accounts to make that type of purchase. Partnering with a bank can accelerate your path to homeownership or a real estate portfolio.
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How does leverage investing work?
Leverage investing amplifies your gains and losses. It’s only a suitable investment strategy for people with high risk tolerances. In the previous scenario, an investor ends up with 100 shares instead of 50 shares due to leverage. In both cases, the investor puts down $10,000 of their own money.
If the stock goes up by $10, it’s great for the leveraged investor. The investor with 50 shares will only see a $500 gain, while the leveraged investor with 100 shares gets a $1,000 gain. As the stock rises, the gap between the leveraged and non- leveraged investors grows.
However, losses compound quicker if you are leveraged. Assume that the same stock drops by $20. The non-leveraged investor only loses $1,000, while the leveraged investor loses $2,000.
Individual investors can hold onto their stocks and wait for the market to change course. However, leveraged investors do not always have this choice. Brokerage firms can initiate a margin call if your account falls below a certain threshold.
During a margin call, you must put additional funds into your account to hold onto your securities. The brokerage firm can automatically sell some of your stocks to cover the margin call without considering how it will impact your capital gains tax. Non-leveraged investors don’t have to worry about this detail.
Leverage investing strategies
Due to the risks, it’s important to know your investment strategy before you get into leveraged investing. You don’t have to use leveraged investing to capitalize on these strategies. However, leverage can result in higher gains if you choose the right assets. Granted, it’s also possible to increase your losses.
These are some of the strategies investors can consider.
Buy and hold
Some investors use the extra purchasing power from their margin accounts to buy additional shares of their favorite stocks. This strategy can be most effective during a correction.
Stock corrections offer low prices that investors may not see for a while. Rather than only buying a few shares, investors can use leverage to experience more potential upside when the stock market recovers.
A buy-and-hold approach also doesn’t work if you pick growth stocks at the height of a bull run. When using significant leverage, stock market timing becomes more important since many investors try to avoid a margin call. You can also use less leverage to mitigate the risk of receiving a margin call.
For instance, investors can consider buying 50 shares with your cash position and 50 shares on margin instead of buying 50 shares with their cash positions and only 20 on margin. Investors can then sell off some of their stocks at a gain to cover the margin debt or use future money transfers to repay the margin instead of investing in additional stocks.
Investors can also accumulate leveraged exchange-traded funds that follow popular benchmarks like the S&P 500 index. While these ETFs can soar if their underlying benchmarks gain value, they can collapse if the underlying index fund loses value.
Leveraged ETFs also have high expense ratios that can exceed 1%. These ETFs are more suitable for short-term trades than for investors who prefer to buy and hold their investments.
Cash flow
Some investors use leverage to buy cash-flow-producing assets. These investors hope that the cash flow from their investments can gradually repay the debt. The investors then acquire an asset without using any of their own money to cover the debt.
Dividend investors face an uphill battle when realizing this goal. You will need over $1 million in margin to get a 9.25% margin interest rate in Fidelity. Most dividend stocks don’t have yields above 9.25%.
The few stocks with yields that high are either struggling businesses due to cut dividends or corporations that issue non-qualifying dividends. Non-qualifying dividends are taxed as ordinary income instead of capital gains.
And that’s assuming you have $1 million sitting around. The interest rate is currently 13.575% if you have a debt balance ranging from $0 to $24,999. You can find a lower rate with Interactive Brokers, and you may find even lower rates if you shop around.
However, this property still has a 6.83% interest rate if you have a balance below $25,000. You also need $1.5 million to get a 6.28% interest rate. Dividend stock yields aren’t keeping up with those rates.
Dividend growth investors may have a better chance with this strategy since they can sell some of their shares after realizing stock gains. However, that strategy also comes with risks since some dividend growth stocks can drop and stay at their lower price points for a while.
Options traders who use covered calls and cash-secured puts also have the potential to realize a return from this strategy. Investors can sell calls with far-out expiration dates to realize an instant lump sum. They can then use those funds to cover the margin.
The downside of covered calls is that they limit your upside. However, you can reduce debt right away, especially if you sell a covered call that is deep in the money. Cash-secured puts have a similar dynamic. You can still lose money if the stock falls far enough, but you get an instant premium. If the covered call or cash-secured put expires more than one year from now, it counts as a long-term capital gain.
Cash flow from leveraged investing is more suitable for real estate investors. These investors can take out 30-year mortgages that substantially reduce their monthly payments. Long-term mortgages result in more interest, but most real estate investors can overlook this fact if rental income always exceeds the monthly mortgage payments and other costs.
As long as cash flow exceeds the monthly cost of debt and other obligations related to the asset, the investor can pay off the debt without tapping into their own cash. The asset pays for itself.
Working With Advisors Can Provide More Security than Going at It Alone.
- SmartAsset's free tool matches you with up to 3 financial advisors that serve your area in 5 minutes.
- Each advisor has been vetted by SmartAsset and is held to a fiduciary standard to act in your best interests.
Short-term trades
Short-term trading with margin combines two risky approaches. Investors using this strategy can expect immense portfolio volatility. A few people can 10x their returns quickly, but most people using this strategy end up quickly burning through their money.
Derivatives like options already have built-in leverage. Using leveraged investing to get additional exposure to a leveraged asset is akin to playing with fire. It’s less risky to use leverage in conjunction with short-term stock trading. You can close out your positions by the end of the day, and you don’t have to trade every day.
Getting out of positions and not always participating will reduce your margin interest payments. Your investment portfolio will also be less vulnerable to overnight developments that impact asset prices. However, you will also have short-term capital gains, assuming you consistently make profitable trades.
If you get involved with short-term trades, you must know technical analysis. Monitoring trading charts and technical indicators can help traders spot opportunities more likely to generate profits. You also have to know when to exit positions.
Some people stay in their trades for too long and turn gains into losses due to getting greedy.
Short-term trades can result in emotional decisions since subtle price swings weigh heavily on your portfolio’s future performance. Investors can also set limit orders that specify which price points to buy and sell specific securities.
How to determine which investing strategy is right for you
Investors can choose from several strategies and assets. Leverage gives them more choices, but it’s not a suitable path for every investor. Leverage investing is only for investors with high-risk tolerances, but a high-risk tolerance won’t shield you from substantial losses.
Investors should assess their financial situation and determine their long-term investment goals before investing capital. The general goal is to make more money and live a good life in retirement, but what does that actually look like? It’s different for each person based on their lifestyles and ability to adapt. It’s also important to set realistic expectations and know what it takes to exceed them if necessary.
People seeking leveraged cash flow may want to consider real estate instead of dividend stocks. However, real estate is a lot more work than buying stocks. It’s important to consider if you have the extra time to manage a property or communicate with a property manager.
Pros and cons
Pros
- The possibility of significantly outperforming the stock market
- You can use the margin to cover other purchases like home improvements
- No credit check for margin loans and a quicker approval process
- Access more margin if you invest more money into your account
Cons
- Potential losses can be significant and wipe out your portfolio, regardless of its size
- High-interest rates
- Spending too much time in your portfolio and becoming more vulnerable to emotional trading
Working With Advisors Can Provide More Security than Going at It Alone.
- SmartAsset's free tool matches you with up to 3 financial advisors that serve your area in 5 minutes.
- Each advisor has been vetted by SmartAsset and is held to a fiduciary standard to act in your best interests.
The bottom line
Leverage investing is a risky business that can lead to higher returns. However, it’s more likely to result in significant losses. The emotional toll of leveraged investing can lead to unproductive decisions that drain your portfolio of funds.
Real estate is more useful for leverage investing since you can use rental cash flow to pay off the mortgage and other costs. Real estate investors also benefit from inflation, resulting in higher rent payments, while fixed mortgage payments remain the same.
A big concern with leveraged investing, especially with stocks and derivatives, is its ‘Hail Mary pass’ nature. Wikipedia defines this pass as “typically made in desperation, with an exceptionally small chance of achieving [the desired result].”
It’s an accurate way to describe leverage investing. Having more shares of your favorite company is a nice perk and can position you for more upside. However, leverage investing makes your portfolio more sensitive to market timing than time in the market.
Most investors should focus on what they can control, such as their income growth. Picking up side hustles, developing skills, job hopping, and exploring new career opportunities can help you achieve your personal finance goals sooner. You have more control over those factors. On the other hand, you have zero control over how a stock will perform during any timeframe. You might also seek financial advice from an expert financial advisor to help you choose the right investment products based on your risk appetite.
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Writer
Marc Guberti is a business freelance writer who specializes in personal finance, digital marketing, and entrepreneurship. His award-winning book "Content Marketing Secrets" teaches readers how to create, promote and optimize content for growth and revenue. Marc also hosts the "Breakthrough Success Podcast," where listeners learn how to master content marketing and get more clients.
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