Thursday, March 5, 2009

Should you use leverage?

All blog entries at Rotten Investments are subject to our DISCLAIMER.

"Leveraging" is nothing more than the act of structuring a portfolio to move faster than some underlying benchmark. You can achieve that effect in multiple ways... by buying on margin, using derivatives like call options, or holding futures contracts. All of these strategies entail a different, and greater, level of risk that merely buying and holding an index product. Be certain you understand those risks before you engage in this kind of behavior.

If anything, the events of the past six months may serve as a lesson for why you should not use leverage. Leverage is a wonderful thing when markets move in the direction you anticipate. Leverage magnifies gains. But when the market moves against you? It's a real bitch. Leverage magnifies losses. As painful as a 50% drop from the market highs of 2007 has been, if you were just holding onto an index fund, you're still in the game and your portfolio should recover over time. Plenty of people who were leveraged over the past year and a half are now wiped out.

Now that you've been warned of the potentially devastating effects of a leveraged portfolio, you need to consider the benefits of taking on some leverage now. One attractive alternative at your disposal is the LEAP call option and the prices for these products right now are very intriguing. A call option is a financial product that gives you the right, but not the obligation, to buy the underlying asset at a certain price [the "strike price"] on or before a certain date [the "expiration date"]. "LEAP" ["Long-term Equity AnticiPation"] merely designates an option with a longer duration. The vast majority of options trading is done in contracts that expire within a few weeks or months. When LEAP's are originally listed, their expirations are typically several years into the future.

I think current market conditions justify a look at the December 2011 LEAP calls on the S&P 500 Depository Receipts [root symbol: "SPY"]. Someone who is currently long SPY could moderately leverage their position with the right SPY LEAP calls. Yesterday, with SPY closing at 71.73, the $25 LEAP calls on SPY for December 2011 [symbol: "OBMLE"] could be had for around $47. An investor who swaps his "SPY" dollar-for-dollar into an "OBMLE" position would end up with a leveraged position of around 1.5. A $1 move in the old "SPY" position would result in a $1.50 move in the new "OBMLE" position. Using the December 2011 contracts affords you over 2 1/2 years to catch a recovery in the markets.

You must have a stomach for risk if you're going to try this. If the S&P (currently around 700) is at or below 250 in December 2011, you will be wiped out. If the S&P is significantly below 700 in December 2011, you will endure severe losses. Your portfolio will be even more volatile if you're holding LEAP call options instead of a plain old index fund. However, if, as I suspect, we enjoy a modest recovery over the next two years, this leveraged position will reward you well for the risk you've undertaken.

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