{"id":713,"date":"2024-12-25T20:13:04","date_gmt":"2024-12-25T20:13:04","guid":{"rendered":"https:\/\/fieldsonginvestments.com\/?p=713"},"modified":"2025-09-05T20:55:34","modified_gmt":"2025-09-05T20:55:34","slug":"how-to-use-leverage-to-boost-your-returns","status":"publish","type":"post","link":"https:\/\/fieldsonginvestments.com\/?p=713","title":{"rendered":"How to Use Leverage to Boost Your Returns"},"content":{"rendered":"

Leverage can be a powerful tool in increasing your returns, but it must be used very carefully. This brief guide will attempt to cover margin, hedging, and related issues.<\/p>\n

Financing Your Investments<\/h1>\n

In theory, if your expected returns on an investment are higher than whatever interest you might pay, it makes sense to increase your investments with borrowed money. But there is one important caveat. If your investment has variable returns, that fact can negate the increase.<\/p>\n

For example, let\u2019s say your expected return is 10% and you can borrow money at 7%. (These rates match the long-term expected return of the stock market and typical margin borrowing costs.) If you lose lots of money in the first year and then bounce back in the second and third so that your 3-year compound average growth rate (CAGR) is 10%, you still might end up worse off than if you hadn\u2019t borrowed any money at all. This is due to what\u2019s called sequence-of-returns risk. For example, let\u2019s say you have $10,000 to invest and you borrow $5,000 at 7%\/year interest. Your portfolio goes down 40% the first year, so you have $15,000 \u00d7 60% \u2013 7% \u00d7 $5,000 = $8,650. Your portfolio goes up 8% the second year, so you have $8,650 \u00d7 108% – 7% \u00d7 $5,000 = $8,992. The third year you bounce back with your portfolio, scoring a 105.4% return for a CAGR of 10%. Your portfolio is now $8,992 \u00d7 205.4% \u2013 7% \u00d7 $5,000 = $18,120. At this point you pay back the $5,000 in debt for a total three-year return of $3,120. If you had invested your $10,000 without using any debt, though, your return would be 1.13<\/sup> \u00d7 $10,000 – $10,000 = $3,310, which is significantly higher.<\/p>\n

So financing your investments with debt only makes sense if at least one of the following is true: a) the difference between the expected return and the interest charged is quite large; b) the expected return is relatively steady; c) you minimize your short-term losses by using an effective hedge.<\/p>\n

The only two relatively inexpensive ways to finance your investments that I\u2019ve been able to find are cash-back mortgages and margin. The interest on both can be deducted from your taxes. Other loans tend to be far more expensive. Mortgage financing is relatively straightforward and cheap if you get a fixed-interest mortgage. I did this twice and due to compounding effects I made a huge amount of money hereby. Margin, however, is considerably more complicated.<\/p>\n

Margin in a Nutshell<\/h1>\n

If you obtain margin on your portfolio, you borrow money from your broker using the securities you own as collateral. The amount your broker will allow you to borrow will depend on the value of your securities. If you borrow a significant amount and the value of your securities drops, you may face a margin call, asking you to deposit more cash in your account to cover the margin. If you fail to do so, the broker will liquidate your positions in order to settle the debt. This could wipe you out completely. Believe me: this happened to one of my best friends.<\/p>\n

There are two basic types of margin: Regulation T margin and portfolio margin. Portfolio margin is significantly more difficult to obtain.<\/p>\n

The Basics of Margin<\/h1>\n

Every position in a margin account has a margin requirement. At most brokers, the margin requirement is 100% for small, illiquid, foreign, and\/or OTC stocks, as well as for uncovered options positions. At Fidelity, the margin requirement drops to 30% for very liquid stocks that are not concentrated positions or that are in sectors that comprise less than 20% of your portfolio. Margin requirements will vary between 30% and 60% for positions that are in-between those two extremes. For stocks whose price is between $3 and $10, the margin requirement will often be $3 per share.<\/p>\n

Margin requirements are not intuitive, so let me explain their significance.<\/p>\n

Below is a snapshot of the positions in my margin account at Fidelity in early October, along with their margin requirements.<\/p>\n

\"Margin<\/a><\/p>\n

The totals of the numbers in the \u201cPosition Value\u201d column are the market value <\/em>of my holdings (around $643,409). The \u201cDollar requirements\u201d column consists of a) if the percentage requirement is a percentage, the product of that percentage and the position value; or b) if the percentage requirement is a dollar amount, the product of that dollar amount and the number of shares held. The total dollar requirements amount to about $265,404. At this point I had $223,185 in debt (this is not shown on the above chart). So my margin equity<\/em> was the market value minus the debt, or $420,224. And my surplus <\/em>was the margin equity minus the dollar requirements, or $154,820.<\/p>\n

The surplus <\/em>is the number you must watch <\/em>if you\u2019re using margin. As you can see, if the requirement is high (100% or $3 on a $3 stock), your surplus will be low, while if the requirement is low, your surplus will be high.<\/p>\n

How much margin was I using at this point? Well, the amount of debt divided by the market value was about 35%, so I was using 1.35X margin. This number has a direct impact on your returns. For every dollar your investments gain you\u2019ll be richer by $1.35; for every dollar your investments lose, you\u2019ll be poorer by $1.35.<\/p>\n

I have only faced a margin call once, when I was almost finished depleting a margin account. The key to avoiding calls is to always keep an eye on the surplus<\/em>. Because margin requirements can go up at any time, I calculate what the surplus might be if all my margin requirements went up by 5% and my securities all went down in value by 20%, and keep that possible future surplus above zero. If the VIX (the CBOE Volatility Index) is high, I increase the 20% in the above sentence to 25% or 30%.<\/p>\n

Reg T Margin<\/h1>\n

It\u2019s not really essential to understand the rules of Regulation T Margin, which are very complicated. Suffice it to note three things.<\/p>\n

    \n
  1. Reg T will effectively cap your margin use at 2X, even if your margin requirements are all 30%.<\/li>\n
  2. If your securities appreciate, your Reg T surplus can go up, but if your securities depreciate, it won\u2019t go down unless you buy or sell something in your portfolio. In other words, a market crash will not cause a Reg T call.<\/li>\n
  3. Your broker will very likely stop you from doing anything that would result in a Reg T call.<\/li>\n<\/ol>\n

    Portfolio Margin<\/h1>\n

    Portfolio margin allows one to evade Reg T requirements; typically the margin requirements can be as low as 15% to 18%. The entire portfolio behaves as if it has one overall requirement. This allows you to use a positively unhealthy amount of leverage (up to 6X in some cases), and can result in very risky behavior. But it also makes your life considerably easier because you\u2019re much, much less likely to be in danger of a margin call as long as you keep your leverage below 2X or 3X.<\/p>\n

    Different brokers have very different requirements for portfolio margin. Fidelity rarely grants it; Interactive Brokers grants it frequently but if you\u2019re trading heavily in microcaps or foreign stocks the margin requirements are onerous. StoneX, the broker for my hedge fund (Fieldsong Investments), has allowed me to use portfolio margin, and it\u2019s considerably easier to use than Reg T margin.<\/p>\n

    Leverage and Hedging<\/h1>\n

    Without a hedge, the use of leverage can be disastrous. Because leverage multiplies one\u2019s losses just as much as one\u2019s gains (or more if you count the interest you pay), the risks one faces when using leverage are enormous. That\u2019s why it\u2019s advantageous to hedge your portfolio when using leverage.<\/p>\n

    I\u2019ve been using put options on stocks likely to collapse to hedge my long equity positions. I\u2019ve written about this strategy here<\/a>. This kind of hedge is useless at counteracting small losses, and loses a huge amount of money during periods of market gains. But during significant corrections and bear markets, it tends to increase stratospherically. Below is a chart illustrating the relationship between a put hedge and the returns of a portfolio of the underlying stocks. This is based on the actual returns of my own investments in puts and assumes a portfolio of a dozen or more underlying stocks and a holding period of about 100 days.<\/a><\/p>\n

    \"Put<\/a><\/p>\n

    You can see that if the portfolio has no gain or loss, the hedge loses between 5% and 10%. If the portfolio gains 20%, the hedge will lose about 40%. If, on the other hand, the portfolio goes down 10%, the hedge will go up between 15% and 20%, and if the portfolio goes down 20%, the hedge will go up about 50%. By the time the portfolio goes down 30%, the hedge will have gone up over 100%. Here\u2019s a rough formula: y <\/em>= \u20138.3x<\/em>3<\/sup> + 3x<\/em>2<\/sup> \u2013 2x<\/em> + 0.07, where y <\/em>is the put hedge return and x <\/em>is the portfolio return. (Remember that this is assuming a 100-day period.) This formula was derived from the trendline in the above chart.<\/p>\n

    You can easily see, then, that a hedge like this will make it much easier, safer, and more profitable to use margin. There are other hedging options too: you could sell short a portfolio of stocks, or you could invest in an inverse ETF.<\/p>\n

    Here\u2019s a graphic illustration of what can happen when you combine leverage with a hedge:<\/p>\n

    \"Leveraged<\/a><\/p>\n

    You\u2019ll see that in this example the put hedge alone loses money: a lot of money. Between 1999 and today it loses more than 99% of its value. But with regular rebalancing, it shores up the returns during downturns. Here are the numbers:<\/p>\n

    \"Leveraged<\/a><\/p>\n

    (CVAR is the conditional value at risk at 10%, which means the average of all monthly returns below the 10th percentile of monthly returns. In my opinion, CVAR at 2%, 5%, 10%, and 15% are the best measures of risk available.)<\/p>\n

    These are, of course, hypothetical portfolios, and your actual portfolio may differ a great deal from them. I\u2019ve done a huge amount of playing with various scenarios, and I\u2019ve settled on a relatively conservative strategy for my hedge fund: use around 1.3X to 1.4X leverage and hedge that with around 8% to 10% puts. Feel free to try your own backtests, though, to come up with your own levels. Here are some rough guidelines:<\/p>\n

      \n
    1. Don\u2019t be too optimistic. Never backtest a best-case scenario. Even a realistic scenario based on actual out-of-sample returns is probably not bad enough for a good backtest. You\u2019re better off preparing for a worst-case scenario than aiming for realism.<\/li>\n
    2. Don\u2019t look only at CAGR. Also look at median quarterly returns and CVARs.<\/li>\n
    3. Backtesting for a high Sharpe ratio will almost never favor the use of leverage, no matter how well you hedge. The same is true for CVARs. That\u2019s why it\u2019s important to balance measures like these with actual returns, whether they\u2019re compounded or median.<\/li>\n
    4. While I\u2019ve always advocated using alpha as a portfolio return measure, it\u2019s useless when a hedge is involved. A few years ago I came up with a mathematical proof<\/a> that when the market as a whole is showing positive returns, alpha and beta are inversely correlated. A hedge, whether it\u2019s put-based or short-based, is going to radically decrease your beta, and therefore increase your alpha. If you\u2019re looking for a very high alpha in your backtests, you\u2019ll be favoring a much higher use of your hedge than is healthy for a portfolio.<\/li>\n
    5. Think of an unlevered unhedged portfolio as a base case. In no event do you want your CVARs or returns to be lower than that.<\/li>\n
    6. While it\u2019s not very hard to adjust a short-based hedge depending on market conditions, it\u2019s difficult and expensive to do so with a puts-based hedge. When backtesting, take into account that increasing or decreasing a hedge is a slow process. If you\u2019re aiming for, say, a 10% hedge and the market takes a huge downturn, your hedge will balloon and it might take you a while to get back down to 10%; similarly, a huge upswing can cut your hedge percentage in half in a few days, and it\u2019ll take some time to build it back to 10%. Options have a built-in time decay: they lose some of their value every day. This means that buying and selling puts has an opportunity cost that holding them doesn\u2019t incur. Not only that, but their spread costs tend to be huge. That\u2019s why it\u2019s best to buy and sell puts slowly to avoid any unnecessary transactions.<\/li>\n<\/ol>\n

      Unhedged Leverage: An Example<\/h1>\n

      In January 2022 I established a private foundation for charitable giving. I decided at the time to maximize my use of leverage by avoiding non-marginable stocks, and I did not use a hedge. To buy and sell stocks I use ranking systems I\u2019ve designed on Portfolio123 (I also use those to determine which stocks to buy puts on). The returns have been very good: a time-weighted annualized return of 37%.<\/p>\n

      Significantly, however, this is lower <\/em>than the returns I obtained managing very similar portfolios for my wife and my kids over the last three years, without using any leverage at all.<\/p>\n

      Part of this is due to the fact that in the Foundation account I only invest in marginable stocks, which excludes some Canadian and European stocks and all US OTC stocks, as well as a number of microcaps. But in addition, leverage is expensive (margin interest is not cheap on a highly levered portfolio), and the increased volatility, as I showed above, can harm overall returns. So at this point I\u2019m planning to add a hedge to my foundation account. We\u2019ll see how that goes . . .<\/p>\n

       <\/p>\n

      My CAGR since 1\/1\/2016: 40%<\/p>\n

      My top ten holdings right now: PSIX, DSP, MNDJF, BKTI, CRNT, ACT:DEU, FLXS, DTLIF, MSB, DNGDF.<\/p>\n","protected":false},"excerpt":{"rendered":"

      Leverage can be a powerful tool in increasing your returns, but it must be used very carefully. This brief guide will attempt to cover margin, hedging, and related issues. Financing Your Investments In theory, if your expected returns on an investment are higher than whatever interest you might pay, it makes sense to increase your […]<\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[],"class_list":["post-713","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/posts\/713","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=713"}],"version-history":[{"count":2,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/posts\/713\/revisions"}],"predecessor-version":[{"id":1219,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=\/wp\/v2\/posts\/713\/revisions\/1219"}],"wp:attachment":[{"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=713"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=713"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/fieldsonginvestments.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=713"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}