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Lessons in leverage, an update

My fake portfolio with 100 shares of Caterpillar stock bought for $1,000 down and the rest on margin is now worth less than zero. Nice thing about fake portfolios: no real margin calls!

For new readers: I posted an item in late December explaining how I accidentally created a leveraged stock portfolio by buying 100 shares of Cat at $42.33 but funding it with only $1,000. With $1k of my own (pretend) cash and $3,233 in (pretend) borrowed money, I created a three-to-one leverage ratio, which was tripling my gains in the Santa Claus rally at the end of the year and is now tripling my losses with Cat revisiting its 52-week low.

In real life my broker — from whom I borrowed $3,233 — would’ve had me on the phone hollering “where the hell’s my money?” long before my cash balance ran to zero. But I’m sticking with my charade trade to see how it plays out over the long haul and to remind myself (and the rest of you following along) of the risks of trading on margin.

All professional traders use margin — which is why the prospect of falling interest rates makes the market rally (and why prospects for a rally now are so grim, with interest rates bumping against the zero limit) — but they also hedge their risks with futures, options, credit default swaps and such. They kinda/sorta know what they’re doing (except when they don’t).

My three-to-one margin bet on the stock market looks borderline foolish in the context of this experiment, but if you put 10 percent down on a $100,000 mortgage, you’re using 10-to-1 leverage. If you sell that house two years later for $120,000 you’ve doubled your cash investment. (The difference being that your home’s value will not fluctuate like a stock’s value because a house has inherent value as shelter while a stock is a piece of paper).

Disclosure: I own no real shares of Cat.

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Tom Mangan posted at 11:34 am January 29th, 2009 |

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