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Using Leverage to Reduce Risk

Steven Smith

In Scott Rothbort's recent article on how to handle market stress, he recommends getting rid of leverage by paying down any margin balances in your portfolio .

He explains his reasoning by writing, "Leverage is a wonderful thing when the markets are going your way. However, during periods of increased volatility and declining markets, leverage can work against you ... and erode your portfolio much faster than if you did not employ leverage at all."

And he is absolutely right. Don't become a deer stuck in the headlights -- take some action to avoid being flattened.

He Who Hesitates Is Lost

I certainly agree that leverage is a double-edged sword, and traders who "lever up" in an attempt to boost returns must realize that the magnitude of potential losses also increases.

But it's worth keeping in mind that you can use leverage to reduce risk before volatility increases and positions turn against you. This, of course, could be accomplished by including options as part of your positions or portfolio to control losses from the outset.

The simplest strategy is the purchase of put options to limit the loss incurred if the price of the underlying asset declines. This is known as a married put. Like most insurance, it comes with a cost that will have a drag on returns. But thanks to the leverage of options, a small amount of money can buy you a lot of coverage.

The cost, like that of insurance, will, of course, depend on several factors. For example, the term or amount of time, because the longer the policy, the lower the annualized cost. Also, the condition of the asset being insured must factor in.

Rothbort suggests avoiding high-beta stocks, as these are thought to carry more risk. An analogy would be a house sitting on a fault line or a pack-a-day smoker, both of which will have higher insurance premiums. Finally, you must decide what size deductible or out-of-pocket loss you are to willing to accept.

An Apple Today

Let's use Apple (AAPL Quote - Cramer on AAPL - Stock Picks) as an example, as it has a relatively high beta of 2.24. That means if the market at large or, say, the S&P 500 rises or falls 1%, shares of Apple should experience a 2.24% change in price. So, as a stock that is expected to move or produce returns, profits or losses, more than twice that of the broad market, one can consider it fairly risky, and therefore its insurance will be relatively expensive.

With Apple currently trading around $131 a share, you can buy the April puts with a January 2008 expiration for $15 per contract. Assuming you owned 1,000 shares of Apple, a reasonable amount of coverage might involve buying 10 of these puts, which would cost $15,000, or nearly 16% of your investment.

What do you get for that 15 grand? First, understand that currently the delta of these puts is around 0.50, meaning that for each $1 move in the price of Apple shares, you can expect the value of the puts to move 50 cents. So, at the moment, your deductible on any initial decline in the stock price is around $7,500, or 5.7% of the investment.

But since delta moves on a slope, meaning it increases as the options move further into the money, your full coverage -- or where the value of the 10 put options will increase on a 1-to-1 basis for each dollar decline in Apple stock -- will begin at around $115 per share.

A Pre-Emptive Strike Price

Now how does that compare to simply selling off shares to reduce your margin requirement? Selling 1,000 shares of Apple at $115 will result in the same $15,000 loss as buying those puts, but it still leaves 900 shares, or some $103,000, exposed to further losses.

The leverage provided by the put option prevents incurring any further losses over the next eight-month period. Also, you still own that full 1,000 shares, meaning you retain the same upside potential should Apple resume its rally.

For a stock that has gained more than 160% from $50 to $131 over the past 52 weeks, this seems a reasonable price to protect this investment. Let's face it, like that house sitting on a peninsula in the middle of hurricane alley, it takes only one small squall -- such as a problem with the iPhone batteries or a backlash against the contracts that offer a limited choice of carriers yet long-term commitment -- to knock down what underpins the high growth projections.

On the flip side, if it all lives up to its promises and the iPhone and other Apple products have blowout holiday sales, the stock could easily rise above $200 by next April, a 53% gain.

Now no one wants to give away nearly 25% of that profit -- remember that the purchase of these puts moves your effective cost basis or purchase price up to $146 a share -- but it's a lot easier to be magnanimous knowing you stand to gain 25% or more while your losses are limited to just 15% of your original investment. The lesson: While leverage has its downside, by applying it in a pre-emptive fashion, you will be well-positioned to reap the advantages of its upside.

This column was originally published on RealMoney. For more information about subscribing to RealMoney, please click here.