In the context of investing, leverage means using additional money that’s taken out as a loan to invest into a product that is expected to produce higher returns. If someone takes a bank loan of 4% interest to create a coffee shop that can produce 20% return within the year, they will have made successful use of leverage.
There are also other forms of leverage available such as using options and futures within the stock market. By buying these derivatives, an individual can create a stake in a company that amplifies a bet times 100. Someone can purchase a call on Apple (AAPL) stock at $200 and when the price increases by 10%, they can cash in on the call for a sizable profit (representing 100% gain – the cost of the call). The potential to produce substantial returns by the use of derivatives may explain the proliferation of “options or future(fx) traders” out there. It’s a way to get involved in the stock market with relatively low sums of money and potentially produce significant income. While the potential for higher income is available, there are multiple risks that become present once you introduce derivatives into your investment portfolio.
1. Derivatives amplify your potential for profit…and loss.
Sure, you can make a lot more money with derivatives but you now also have the potential to lose a lot more money. If you’re wrong on a specific bet, then you could end up with a derivative that is worthless. The potential for your portfolio to go to 0 becomes much more steeper. Even if you are using derivatives in a way that is meant to lower the risk of short-term volatility, you pay extra for that type of insurance. If you end up being wrong even 3-5 times in a row, which can be very easy to do, you may find out that your entire portfolio gets wiped out.
2. Once you take a major loss, your psychology will highly encourage you to continue…much like that of a gambler.
Assuming at some point you do lose a major portion of your money by taking a higher risk bet on a derivative, that type of loss will incentivize you to take even riskier bets. Once your portfolio is down 40%, you would need to make 66% on your money to hit break-even point again. With a need to hit break-even again, you’d realize that the fastest way to get back there again is an even bigger risk. This type of psychological reasoning keeps you in the game until you have no chips left to play.
3. Once you take a major gain, your psychology will be influenced to take risky decisions as well.
Let’s assume you gain 40% or even 100% within a very short time period. The risk and bet you have taken will prop up your psychology to become more confident and take even bigger risks, as you might reason that it will continue to be that easy. After increasing your money by however much, you may find that you get attached to that larger number. Then, assuming you lose a good sum on a wrong bet (which would be inevitable the longer you are “playing the stock market”), you become incentivized to play out the psychological dynamics discussed in #2.
4. Derivatives can expire over time ranging from a few days to years, introducing a market timing element to the investing.
Because there is an expiration date on the derivative, you not only have to be right but you need to be right about when it will happen. The timing aspect of derivatives can cause a rushed feeling within your psychology, causing you to take bets that backfire inappropriately. Time works against you when it comes to derivatives, which is unlike buying and holding securities for the long-term (longer holding periods is associated with increased returns).
Thus, there are many potential dangers to using derivatives in investing. For a long-term investor who desires to increase their earnings without the influence of nefarious psychological tendencies, a simple buy and hold approach would suffice.