Leverage: Yes or No?

Certain words by the way they get tainted and taken in bad light. While some of them are so, few are not. A simple example of it is the term “speculation”. While in general parlance it is treated negatively, but is it so? I don’t think so. There is a stark difference between speculating and gambling but people use it anonymously. Just risk and uncertainty are treated.

How do risk and uncertainty differ? Well, risk means, one knows all possible outcomes but does not know which will be the final outcome. It is measurable and so controllable. For instance, during elections the winner can be ruling party or opposition party. The outcome is clear and one can hedge against any negative outcome. As for uncertainty, it is a situation where future events are not known and so they are not measurable and controllable.

How do speculation and gambling differ? So, gambling involves a game of chance. Generally, the odds are stacked against gamblers. When gambling, the probability of losing an investment is usually higher than the probability of winning. Because one is playing uncertainty without any risk management in place, gambling has a high potential of losing the investment.

Speculation involves calculating risk and conducting research before entering a financial transaction. A speculator buys or sells assets in hopes of having a bigger potential gain than the amount he risks. A speculator takes risks and knows that the more risk he assumes, the higher his potential gain. However, he also knows that he may lose more than his potential gain.

So, while a speculator takes risk; gambler plays around uncertainty. The difference between the two is stark, still both the terms are use in the same breadth.

Leverage and unscrupulous trading face similar issue. People use both the terms as same. Leverage is nothing but using borrowed money to make financial gains. While unscrupulous trading is borrowing more than one’s risk/loss taking capacity.

We leverage ourselves many times in life; a home loan or a business loan is a form of leverage. You put in certain amount which is yours and rest is funded. So, when one uses leverage by paying margins and takes benefit of the full position it is leverage and not unscrupulous trading. But, if one takes position much more than what he can fund via mark to market losses that’s unscrupulous trading.

Why to leverage? The answer is lies in the concept called RoI (Return on Investment). Returns on a trade can be calculated on various measures like, RoI, absolute returns, compounded annual growth rate (CAGR) etc. For individual investors with limited trading capital the best form of trading returns is high RoI. Absolute returns in case of such investors would not matter much.

For instance, you have a trading capital of Inr 10 lakhs and you buy Axis Bank at today’s price of Rs. 730/- with a target of Rs. 800/-. In cash market you can buy ~1,370 shares indicating a gain of Rs. 96,000/-, an absolute return of 9.6%. Instead if you use futures, the exposure can go upto 7,200 shares considering ~18% -20% margin and lot size requirement. This translates to a gain of 5,04,000, a absolute return of 50.4%. In first case your capital move from Inr 10 lakhs to ~Inr 10.96 lakhs and in second case it moves to ~Inr 15.04 lakhs.

If one uses options, Axis Bank 800 December Call is currently trading around Inr 10/-, if the stock moves up to 800, by the mid of the series still the call would be worth atleast Rs. 30/-. Considering the lot size one could have bought ~62,400 shares which translate to a gain of Inr 12.48 lakhs. So, basically the returns would be atleast ~125% and the capital would move to Inr 22.48 lakhs.

Now you can see the impact of the leverage that we have been discussing. The only problem here is that while cash position can be held for long time and futures can be rolled at a cost; options decay; thus can lead to total loss of capital. So, one has to weigh the risk – return well before doing this.k

So, hope we use leverage in the correct way rather than using it unscrupulously or avoiding it with a view that it is dangerous. To know more,click here: 

Happy Trading.

Cheers!!!