The Finance Professor: Understanding Leverage

I spent the better part of my career at Merrill Lynch (MER Quote) as a vendor of leverage primarily to hedge funds . You might recall one of them by the name of Long Term Capital Management. LTCM was a master of the use of leverage, which also led to its undoing.

So what is leverage? Leverage comes in many forms. If you've ever bought a house and took out a mortgage, then you've used leverage. In this installment of the Finance Professor, I will shed some light on leverage from the point of view of buying or gaining exposure to stocks or stock indices.

Buying stock with borrowed funds is achieved through the extension of credit from a broker-dealer or other financial institution . Such credit arrangements are regulated by the Federal Reserve through a series of regulations -- Regulation T, Regulation U and Regulation X. Of those rules, Regulation T contains the guidelines that govern the extension of credit by broker-dealers to customers, particularly individual investors who purchase and carry securities. To many people, Regulation T is simply referred to as the "Margin Rules."

The Margin Rules

There are many aspects to the margin rules that you must understand before buying securities on credit. I will discuss those rules in the context of stocks.