Investing using leveraged

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 stock market crash. The initial margin and maintenance margin serve as a cap on the amount that can be borrowed. Of course, an investor that consistently uses the maximum margin available faces an increased risk of a margin call in a market decline.

However, some brokers do provide customers with a way to bypass these minimums by providing certain accounts with portfolio margin. 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 are comparatively high and are usually tiered. For example, a large online broker may charge 7.

Some online brokerages provide a less expensive margin and use it as a selling point. Advantages The advantage of margin loans is that they are easy to use, and the capital can be used to purchase virtually any investment. For example, an investor with shares of Coca-Cola could borrow against those shares and use the proceeds to buy put options on another security. Dividends from the Coca-Cola shares could then be used to help pay the margin interest.

Disadvantages An investor who uses margin can face significant financial risk. If the equity in the account falls below a predetermined level, the broker will ask the investor to contribute additional capital or liquidate the investment position. Stock and Index Futures A futures contract is a 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. Of those, 1. There's also been an explosion in equity options trading, especially in the U. Equity options traded on American securities exchanges jumped Overall, futures and options on equity indices, the largest category of the listed derivatives markets in terms of volume, reached Futures and options on individual equities reached 9.

Costs Although these products have a reputation for being beyond the reach of the typical retail investor , companies are moving 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 on stocks are known as single-stock futures SSF. Investors are required to maintain a cash position in order to purchase a future.

This is often referred to as margin but is actually a performance bond. This provides leverage from 5 to1, to 20 to 1. Advantages Futures contracts are a favorite with traders because of their relatively low bid-ask spreads and the high amount of leverage provided by the contract. Interest costs are also much lower than margin rates; they are calculated as the broker call rate minus the dividend yield paid by the underlying securities. Every futures contract has a settlement date upon which the contract expires, but these dates are relatively meaningless, as most contracts are either sold or rolled forward to a future date.

Disadvantages If the price of the 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 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 expiration date. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people. They attempt to deliver multiples of the performance of an underlying index or benchmark they track. Some track broad indices, while others track specific sectors or commodities. Leveraged ETFs seek to magnify returns by using some of Wall Street's favorite financial drugs: derivatives, futures contracts, and swaps.

Although leveraged ETFs can serve a meaningful purpose to day traders, longer-term investors should steer clear. The leveraged ETF accomplished its goal on a daily basis, but failed to keep pace over the two-day period. This gap can grow significantly for buy-and-hold investors, and be deadly in volatile markets. It's even possible that investors could suffer significant losses while the long-term performance of the underlying index shows a gain.

The dangers of leveraged ETFs have been highlighted in recent years, but brokers and investors are still learning the hard way. Sixty-five customers were involved between the two St. Louis-based broker-dealers. Brad Bennett, FINRA Executive Vice President and Chief of Enforcement, explained, "The complexity of leveraged and inverse exchange-traded products makes it essential for securities firms and their representatives to understand these products before recommending them to their customers.

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