Understanding the Risks and Rewards of Leveraged Investing

Date: May 30, 2023

Retail investors would be familiar with the investment strategy of “buy and hold’’, which emphasizes holding on to your investments for the long term in order to ride out short-term volatility.

The underlying rationale of this strategy is that “time in the market’’ is much better than trying to “time the market’’ because trying to get the timing right over the short term is very difficult.

Trying to time the market adds to investment risk and transaction costs. Furthermore, studies have shown that only a very small proportion of day traders can make consistent money through short-term trading and that most people end up losing money.

What if you want to maximise short-term movements?

However, for those individuals who still want to try and capitalise on very short-term movements and to extract the maximum returns from these ups or downs, there are products available that allow them to do so.

Known as “leveraged products’’ these instruments look to amplify movements of different underlying assets by certain multipliers.

It is important to note that the meaning of “leverage’’, which is essentially “borrowing’’. When you put money in a leveraged product, you are actually borrowing to gain exposure to particular assets.

Contracts for Differences (CFDs): an example of a leveraged product

Leveraged products will almost always require you to pay an initial portion of the position you intend to open. This is called the margin.

A good example of this is Contracts for Differences or CFDs for short.  A CFD allows you to speculate on the future market movements of the underlying asset, without actually owning or taking physical delivery of the underlying asset. CFDs are leveraged instruments. They tend to be traded over-the-counter with a securities firm, known as a CFD provider.

Here is a simple example of how it works:

Suppose you want to trade 1,000 shares of $10 each. The position is worth $10,000. If the CFD provider’s margin is 10%, then you have to deposit $1,000 as the initial margin.

The share price now rises to $11. Your position is now worth $11,000 and you then decide to close it. Your profit is the difference in the two positions, which is $1,000.

The stock rose 10%, but you have made $1,000 – a 100% return which is ten times more.

That’s the power of leverage – for an initial investment of $1,000 you gained exposure to stocks worth $10,000. In reality, the CFD provider has lent you the difference.

Note however, that leverage would work against you in this case if the stock fell to say, $9 and you decide to close the position. Your loss would then be $1,000 or 100% of the initial margin.

Note also what would happen if the stock falls and you don’t close the position.

Margin calls

Suppose the stock price falls to $9.90 and the position is now worth $9,900. Your paper loss is now ($10,000-9,900) = $100. Your deposit value now drops by $100 to $900.

However, the 10% margin requirement for a position of $9,900 is $990. You will therefore receive a margin call of ($990-900) = $90. If you fail to top up your margin when required, you risk having your position liquidated at a loss. Moreover, margin calls can be made at very short notice, especially in volatile, fast-moving markets.

What are the risks of CFD trading?

From the above, it should be clear that CFD trading carries a high level of risk to your capital compared to other kinds of investments, as prices may move rapidly against you. It’s possible to lose more than your initial margin and you may be required to make further payments as margin calls.

Therefore, CFD trading may not be appropriate for everyone, and it is best to study how it works carefully before taking the plunge.

DLCs: another example of a leveraged product

On the Singapore Exchange there are what are known as Daily Leveraged Certificates or DLCs for short, which give traders a leveraged return of 3 to 7 times the daily performance of an underlying reference instrument such as the Straits Times Index (STI) or the Hang Seng Index.

So, if the STI moves by 1% from its closing price the previous day, the value of the 3x STI DLC will move by 3%, and if it is a 5x STI DLC, the value will move by 5%.

DLCs are designed to be traded over short periods of time, predominantly on an intra-day basis. The DLC offers the flexibility to trade both rising and falling markets.

A bullish investor who thinks that the underlying index is set to rise over the trading day can select a 3x Long DLC, which will rise in value by 3% for each 1% rise in the underlying index (before cost & fees).

A bearish investor who expects the underlying index to fall can instead select the 3x Short DLC, which will rise in value by 3% for every 1% fall in the underlying index (before cost & fees).

In a sense, a Short DLC is a form of a “leveraged inverse’’ product, because the value rises when the underlying asset falls and vice-versa, i.e., its value moves inversely to the underlying. However, strictly speaking, leveraged and inverse (L&I) products are structured differently than DLCs so they will be dealt with in a later section.

How much can you lose trading DLCs?

In the case of DLCs, note that losses are multiplied in the same manner as gains, so a large amount can be lost in a very short period of time. However, there is an “air bag mechanism’’ that is designed to cushion or slow the rate of loss in a DLC whenever there are extreme market conditions. Also, the maximum loss is limited to the principal amount invested.

It is important to note that such protections do not exist with all leveraged products, so it is important for investors to familiarize themselves with all the features of the instruments they are considering before taking the plunge.

Leveraged and Inverse Products

Leveraged and inverse (L&I) products are usually structured as open-ended funds and listed on stock exchanges like typical exchange traded funds (ETFs).

Leveraged ETFs are ETFs that multiply returns of their underlying indices, whereas inverse ETFs provide returns in the opposite direction of their underlying indices similar to the Short DLC that was featured earlier.

The returns are achieved primarily through the use of swaps, futures contracts or other derivative instruments.

Just like CFDs and DLCs, these products are not designed for investors to buy-and-hold for the long term. They are meant for active trading purposes.

For example, over a one-day period, there may be an inverse relationship between the inverse ETF and the index, but over more extended periods, the relationship may not be applicable.

Investors should therefore also not expect an exact percentage performance return on their L&I ETFs in relation to the performance of the respective indices. A 2x leveraged ETF will not give an exact 2% increase in return should the index performance increase by 1%.

A final reminder

The bottom line is that all leveraged products are very volatile and are appropriate only for sophisticated tactical traders who may have a very short-term view of the market and are looking to capitalise on it.

Also, all leveraged products require constant monitoring, otherwise losses can add up. If in doubt, it is best to get professional advice.