The Finance Professor: Understanding Leverage

The Lure of Leverage Returns

What makes trading on margin appealing is the seductive aspect of leverage returns. You can plop down $10,000 to buy $20,000 of stock. When that stock goes up 10% to $22,000 your return on your investment is actually 20% ($2,000 divided by $10,000).

On the other hand, you can get wiped out rather quickly by relying on margin. That $10,000 investment in the $20,000 in stock will evaporate if the stock is down 50%. Luckily, the margin calls will kick in before that occurs to force you to ante up or send you a clear sign to get out.

With margin rates (for example) currently at 8.75% at Morgan Stanley (MS Quote), you will have to earn in excess of that rate on an annual basis just to make your (pretax basis) interest payments. With the S&P 500 historically growing on average at about the same rate, you have to be very certain that what you are buying on margin will outperform that index.

How to Avoid the Pitfalls of Leverage

There is some middle ground that I think can help the individual investor. Here are four ways in which you can use margin and leveraged investments to your advantage, or how to trade to avoid the pitfalls of over-leverage:

1. Buy stocks in increments. That way when you want to add to an existing position, you do so from cash and not from credit. An even better approach would be to set up an investing budget so you know how much you are willing to allocate to an individual asset class or holding. This requires patience and discipline but will pay off in the long run.

2. Use margin for a quick event-driven trade rather than long-term investment. Say you want to play Google's (GOOG Quote) earnings for the announcement and conference call. Buy GOOG on margin for the event, but sell it once the news hits the market -- whether you win, lose or draw. Don't turn it into an investment.

3. Margin can be a convenient overdraft protection facility for your portfolio. Say you have a portfolio of $100,000, of which $98,000 is in securities and $2,000 is in cash. There is a stock that you have followed that has hit its entry price point. A round lot of 100 shares would cost you $3,000. Since you are always better off not trading odd lots , buy the stock for $3,000, of which $1,000 is on margin. With only 1% of your portfolio on margin, you really don't have any worries about a margin call or excess leverage risk. Just make sure that your next portfolio transaction is a sell before you buy the next stock.

4. Leveraged ETFs are increasing in popularity, availability and liquidity. The good thing about these ETFs is that they must be bought with cash and cannot be margined. Thus, instead of buying $200 of a regular ETF in a margin account, buy $100 of the leveraged version of the same index ETF in a cash account. Examples of these ETFs are the Ultra S&P 500 ProShares (SSO Quote), Ultra Dow 30 ProShares (DDM Quote), Ultra MidCap 400 ProShares (MVV Quote), Ultra QQQ ProShares and Ultra Russell 2000 ProShares (UWM Quote).

Some Homework:

• If you have a margin account, ascertain the level of risk and the interest cost relative to your potential rewards.
• If you don't have a margin account, consider opening one to use for event trades or trading overdraft protection.
• Become more familiar with the leveraged ETF products, which can achieve marginlike performance without the worries of margin calls and high interest charges.

You can email me your homework and your thoughts on the subjects covered in this article. I will compile the best ideas in a future module of TheStreet.com University.