Archive for the ‘Leverage’ tag
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).
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Disclosure: I own no real shares of Cat.
My accidental lesson on leverage
I learn far more from what I screw up than what I get right. For instance, when I created Cat Stock Blog I started a fantasy portfolio in my Wall Street Journal account. I funded it with $1,000 in fake money, but I mistakenly entered my first transaction for 100 shares of Cat at $42.33, giving myself a balance of minus-$3,233 on the first day. This the equivalent of putting $1,000 in cash down and investing the rest on margin, just like the big boys do (except when they don’t).
Every day I get an e-mail telling me my day’s returns. At first I wondered why my returns were so totally out of whack with the day’s close, the it dawned on me what was happening: The automated portfolio software was accidentally replicating the process of using leverage to juice returns.
Here’s what happened today: On a day when the market fell about 2 percent, my fake portfolio’s net worth plummeted by 13 percent. Three-to-one leverage looks risky as hell in a down market; imagine how careful/crafty/brilliant/lucky you’d have to be if you were floating 30-to-1 leverage like many of the hedge funds and investment banks did until recently.
And people were surprised that there was a crash.