Leverage - A double edged sword!

Leverage is a neutral tool available to the investor. It neither favours helping the investor nor harming him. It is a double edged sword. The outcome of using leverage depends on how it is being used by the investor. So, the investor solely controls and is responsible for the outcome of using leverage, whether leverage will help or harm him.

Leverage is powerful in magnifying returns for the investor when it is used in certain situations and on the other hand destructive in magnifying losses when used in uncertain situations. Thus, leverage is a double edged sword and the wielder of this sword has to be trained in understanding how the sword can be used safety so as to help an experienced and knowledgeable wielder of the sword and not harm an unwary novice wielder instead.

One situation that poses uncertainty in using leverage is in trading of stocks. Stock prices fluctuate and when an investor is taking a position to long a stock or short a stock, there is no certainty that the stock will indeed rise (in the case of longing) or fall (in the case of shorting). No matter how an investor can boast of using technical analytic tools as a basis to enter into a trade, there is no absolute certainty that he can always have his way in terms of predicting the exact movement of a stock price. Thus, we hear of the saying "stop loss" and "cut loss" which are simply measures to minimise the impact of loss due to a stock price moving contrary to what is expected by an investor. In such uncertain situation of stock price movement, there is a hidden potential of leverage unleashing it's destructive nature despite having "stop loss" and "cut loss" measures in place as an investor cannot control stock price movements. As soon as a loss is incurred no matter big or small, leverage will magnify the losses further. 

However, in special situations such as a high probability of an arbitrage deal being completed, much risk would have been removed though a small risk that the deal may not be completed is still inherent as one cannot remove all risks. In addition, the more certain an investor can ascertain the time of completion of an arbitrage deal, he will be able to determine his adjusted projected annual rate of return (see previous post "A look at arbitrage deals using arbitrage risk equation from Benjamin Graham."). Using leverage in such certain arbitrage deal situations will help to magnify the returns for an investor.

I shall present here an example of how leverage can be used in such certain arbitrage deal situations. ABC company offers to buy all shares of DEF company at $10 per share in an acquisition exercise. DEF company agrees to tender all it's shares to ABC company at this price. Public announcements have been made by both companies and many investors of DEF company have tendered their shares and there is no objections from any major investors to block the acquisition. The acquisition exercise is expected to close in four months. Immediately after the public announcement, shares of DEF company are trading at around $ 9.70 per share.

For an investor who bought DEF shares immediately after the public announcement at around $9.70 per share, he will stand to make a return of about 3% in four months when the deal closes. His annual rate of return will be approximately 9%.

                                         = 3% in four months

                                           Annual rate of return = 3 X 3% = 9%

An annual rate of return of 9% may not make this deal overly attractive. However, the situation becomes different when leverage comes into the picture. Imagine that an investor can finance the buying of shares of DEF company at 8% borrowing interest rate per annum. This equates to a borrowing interest rate of around 2.7% for the four months period of the arbitrage deal. This translates to an interest cost at around $0.27.

Interest cost for the four months = 2.7% X cost of shares
                                                         = 2.7% X $9.70
                                                         = $0.27

Having an interest cost of around $0.27 per share and a potential profit of $0.30 per share from the arbitrage deal ($10 - $9.70 = $0.30), there will be a projected profit of $0.03 per share ($0.30 - $0.27 = $0.03).

Note that the cost of a share of DEF company is $9.70 per share, but the investor using leverage is borrowing this $9.70 at an interest cost of $0.27. So, his real investment cost is only $0.27 per share. He will earn a projected profit of $0.03 per share from our earlier calculations.

Thus, his rate of return for the four months is approximately 11%.

                                                                                    = 11% for four months

This translates to a whopping annual rate of return of 33% (11% X 3 = 33% in a year). With leverage, the investor can receive an annual rate of return of 33% compared to without leverage at an annual rate of return of 9%. His actual rate of return in four months time from the arbitrage deal is also higher at 11% with leverage compared to 3% without leverage. In this case, using leverage will approximately triple his returns in the same time period.

In conclusion, certainty when combined with leverage greatly magnifies returns for an investor. When leverage is used in certain situations such as a very high probability of consummation of an arbitrage deal within an announced known time period to completion of deal, an investor can determine his projected profit for the time period with high certainty. Leverage can thus be used as a powerful tool to greatly magnify an investor's returns in situations of high certainty. Wield this double edged sword properly with understanding and knowledge and it will greatly reward it's careful user.  

Leverage - A double edged sword!

To the knowledgeable wielder who wields the sword (leverage) with understanding, it rewards him greatly!