You may have heard the phrase “The House Always Wins.” It refers to casino games that are designed so that the casino (a.k.a. “the house”) always turns a profit at the expense of its patrons. It comes down to simple math: the casino games are designed so that the odds are in favor of the casino and not the gamblers. While an individual may get lucky and win against the house for a limited time period, in the long run overcoming the odds is virtually impossible.
But the stock market is not a casino, contrary to what some people call it. History has shown that, on average, the stock market goes up. In fact, from 1928 through 2020 the stock market averaged returns of positive 12.06% per year, and the market had positive returns in 74% of those 93 years. Clearly, the odds are in favor for stock market investors. These results are based on market averages. The best investors can average greater than 20% annual returns. My mentor, Saul Rosenthal, achieved greater than 25% average returns over a 30+ year period. I believe that I can average greater than 20% annual returns, perhaps more. In this sense, GauchoRico is the house.
LEVERAGE
In investing, there are two forms of leverage.
Leverage Using Debt
Investors can borrowing money and invest that borrowed money into more investments; in this case, the investor is investing money that he does not own. This is similar to using a mortgage to purchase a home. For example, a house with a $100,000 price tag can be bought with $20,000 cash and an $80,000 mortgage or loan. In this case, if the value of the home increases by 5% or $5000, the owner has earned the entire $5000 in appreciation. However, he has made 25% profit on his $20,000 investment. Leverage cuts to the downside as well as to the upside. If the property decreases 25% in value from $100,000 to $75,000, then the owner will still owe the bank $80,000. In this case, the owner has lost not only his entire $20,000 investment, but he’s also lost an additional $5000 that he did not have. This example illustrates that leverage if used to excess can be so dangerous that it could entirely wipe out an investor.
Leverage Using Options
Investors can buy the derivatives (e.g. stock options) of stocks as an alternative to buying the stock itself. When buying an option, the investor is not using any money that he doesn’t already own, but, rather, he is controlling more shares per dollar because the cost of buying an option is less than buying an equivalent number of shares. Unlike with debt financed leverage, the maximum loss on a purchased stock option is 100%. While using options as a replacement for stock may sound great, there’s a catch, actually several catches. First, when buying a stock, the investor can hold the stock indefinitely so if the stock price stagnates for a long period, the investor can wait it out and eventually profit once the stock prices finally rises. Options, on the other hand, have an expiration date after which the option expires or is deemed worthless. Thus, if the stock price doesn’t move to a minimum price within the timeframe that the option is active, then the investor can lose his entire investment. Second, options also have a strike price, which is the price that the stock must be above (in the case of a call option) to have any value at expiration. Call options with a strike price below the current stock price (in-the-money), at the current stock price (at-the-money), and above the current stock price (out-of-the-money) are available for purchase. Out-of-the-money call options are most risky because the stock price must move up the most to have any value at expiration. But OTM call options cost less than ATM or ITM call options. The higher the stock price is above the strike price, the more valuable the option. If the stock price is below the strike price at expiration then the option is worthless. Third, options typically (LEAPS are the exception) have expiration dates less than one year after the time that the options are purchased; therefore, any profits would be considered short term gains and are taxed at a higher rate in some tax jurisdictions. Finally, dividends, if paid on a stock, are not paid on the options of that stock. Thus, the investor is foregoing any dividends by owning call options instead of straight stock.
THE MATH SHOWS LEVERAGE INCREASES AVERAGE RETURNS
Leverage using debt will increase returns so long as the average investment return is higher than the interest rate paid to borrow the funds. For example, if an investor can borrow money at 3% and gains 5% in investment returns then the investor is earning a net 2% on the borrowed funds. It’s actually been much, much better than that: lately, I’ve been paying between zero and 1.25% interest while clocking annual investment returns well in excess of 40%! Conversely, borrowing at a higher rate than the investment returns will result in a net loss. Obviously, this isn’t a good idea. In the investing book “The Davis Dynasty: Fifty Years of Successful Investing on Wall Street,” the author, John Rothchild, describes how Shelby Davis amassed over $900 million from an initial $50,000. Here is an excerpt from the book:
“Davis, who paid cash for his house, would soon be buying stocks with borrowed money (margin). After its losses in 1929 to 1932, the public disparaged margin investing, yet people routinely bought houses with margin loans, aka mortgages. Though they didn’t think of mortgages this way, leverage in residential real estate was a main reason their houses gave them their biggest investment gains over the long term. Davis was confident that leverage applied to stocks was a far more potent profit booster than a mortgage, so he pursued the former and ignored the latter.”
p56 “The Davis Dynasty” by John Rothchild
LOWERING THE COST OF BORROWING
When I can achieve returns greater than 20% per year on average, I’m going to use some leverage. On one side of the equation, I am trying to boost my investment returns (not the topic of this post). On the other side, I am trying to lower my cost of borrowing. I would never employ a high interest loan as a source to fund further investments. There are muchlower loan choices available than 20+ percent rates charged by credit cards.
Using Margin Through the Brokerage Account
Currently, the default margin rate (i.e. interest rate charged to the investor by the broker) is typically 6-9%. These rates are often negotiable if you call your broker to request a lower rate. Larger account values and more trading activity usually give investors more weight to negotiate a lower rate. I recently negotiated my margin interest rate down to 1.25%. The margin rate given by brokerage firms is tied to an underlying rate which can rise or fall causing the margin loan to rise or fall in turn.
Tapping into Home Equity through a HELOC
With interest rates near all-time lows, homeowners may be able to tap into their home equity by opening a home equity line of credit (HELOC). Unlike a regular mortgage, a HELOC can be tapped and paid off repeatedly with interest only changed on the open balance. The rate on a HELOC is almost always linked to another interest rate which can fluctuate up or down.
Selling Deep In-the-Money Puts
The margin that’s available for use in a brokerage account can be utilized to sell puts. Selling a deep in-the-money is similar to buying the underlying stock. However, utilizing the available margin in this way does not incur any interest charges. Therefore, this is a way to use margin without incurring any interest. For example, if CRWD is trading at $120 per share, I could sell a $140 put option resulting in about $20/share or $2000 credited to my account. This $2000 could then be used to buy more stock in CRWD or any other stock.
I have used all three of the above methods to leverage my portfolio. I currently have no HELOC, and I rarely use margin to directly buy stock because I don’t like paying interest. Therefore, I most frequently sell puts and then use the collected cash to buy stocks or long options positions.
THE RISKS OF MARGIN LEVERAGE
Using margin debt to finance stock or other investment purchases is not risk-free. In fact, it can be very risky. Therefore, I only use margin prudently. I reserve a very large buffer of available margin in the event that my investments decrease significantly in value. In the worst case, excessive leverage can completely (and then some) wipe out an investor financially. This could mean losing all the investments including the home that’s used as shelter plus then owing additional money to the brokerage firm. The consequence could mean bankruptcy and completely starting over. Speaking from experience, this could have happened to me in 2015-2016 when I became overzealous about my stocks’ prospects and I used margin to excess shortly before most of my stocks dropped 40-60% in value. It turned out to be one of the most unpleasant times in my life, and I wouldn’t wish that experience on anybody. Below are some of the things that can go wrong when too much money is borrowed to invest.
- The stocks go down in value, thereby lowering the available margin to the investor (i.e. available margin is determined by the value of the marginable securities in the account).
- The brokerage firm changes the percentage of some or all of your stocks that can be borrowed. This can be done without notice. For example, when GameStop (GME) was exploding up at the end of January 2021, most brokerage firms changed the marginability of that stock to 100%, meaning that it was no longer possible to borrow against GME at all. Marginability can also be lowered if certain thresholds, such as a certain percentage of the portfolio’s value is invested in the same sector, is breached.
- The account’s margin limit is exceeded. This will result in a margin call which is a notice that some securities must be sold. Some brokerage firms may start liquidating positions for the investor. Selling after the investor’s stocks have significantly dropped locks in the loss and makes it more difficult to recover from those losses. Forced deleveraging at the bottom is probably the second most unpleasant thing for an investor to experience.
- The interest rate on the borrowed money can be increased. Rising interest rates will also cause the rate on a HELOC and the margin rate offered to an investor by their brokerage firm to increase.
SUMMARY
Margin when used sparingly can juice returns without significant risk of financial ruin. Perhaps margin is less appropriate for less experienced investors and for those who have challenges with staying disciplined or issues with gambling or taking excessive risk.
While using leverage to buy call options limits the loss to the option investment, the limitation of the remaining time until the option’s expiration could lead to a situation where the investor could be right on everything about the stock except the timing of the stock move; this could result in a 100% loss on the option investment. I do use call options, but I’m careful to use them prudently and only under certain conditions. I wrote about one such case in my recent LEAPS post.
The trick to consistent success using leverage is to borrow at a rate that’s far lower than the investment return and to never, ever get into a situation where the leverage is (or could get) so high that deleveraging is forced. To avoid the latter, it’s prudent to always leave plenty of buffer to withstand very large drops in the portfolio’s value. Finally, I believe it’s appropriate to change the phase to “The House Usually Wins.”
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.