The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to help educate investors about the risks of using leveraged investment strategies.
Leveraged Investment Strategies
Leveraged investment strategies attempt to magnify an investment’s return through: 1. borrowing money (margin), 2. using options, or 3. investing in securities that use leverage such as leveraged ETFs. Three common leveraged investment strategies include margin trading, options trading, and leveraged ETF trading. Below, we will discuss examples of these strategies and some risks you should consider before using any of them.
Margin Trading
Margin trading uses borrowed money to purchase or sell short securities. Margin trading occurs in a “margin account,” a type of brokerage account in which your brokerage firm lends you cash (a “margin loan”), using the account as collateral, to purchase or sell short securities. The following example of margin trading shows how the leverage from borrowed money can impact an investment’s return:
Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment (i.e., your $25 gain is 50% of your initial investment of $50). But if you bought the stock in a margin account – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100 percent return on the money you invested (i.e., your $25 gain is 100% of your initial investment of $25). You will also owe your broker interest on the $25 you borrowed.
The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $15. If you fully paid for the stock, you would lose 70% of your money. However, if you bought on margin, you would lose more than 100% of your money. In addition to the 100% loss of your $25 initial investment, you would also owe your broker an additional $10 plus the interest on the margin loan.
Margin Trading Risks
Margin trading is very risky and is not appropriate for every investor. Before you invest using margin consider that:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses (a “margin call”);
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities;
- Your brokerage firm may sell some or all of your securities without consulting you to pay off your margin loan;
- You are not entitled to choose which securities your brokerage firm sells in your accounts to cover your margin loan;
- Your brokerage firm can increase its margin requirements at any time and is not required to provide you with advance notice; and
- You are not entitled to an extension of time on a margin call.
For additional information on margin trading and risks you should consider before using this investment strategy please read our investor bulletins: “Understanding Margin Accounts” and “Margin Rules for Day Trading.”
Options Trading
Options trading refers to the buying and selling of options. Options are contracts that provide the holder with the right to buy or sell an underlying asset, at a fixed price (also known as the “strike price”), on or before a specified future date. These underlying assets can include, among other things, stocks, stock indexes, ETFs, fixed income products, foreign currencies, or commodities. Instead of borrowing money to purchase more stock, options create leverage through their contractual terms. The following comparison of a stock and options purchase shows how leverage works with a typical options trade, and how this leverage may impact an investment’s return:
On December 1, 2020, ABC Stock is trading at $68 per share and you believe the price of ABC stock will rise soon.
Stock Purchase. You purchased 100 shares of ABC Stock at a cost of $6800. Two weeks later, the price of ABC Stock rises to $80 and you sell your 100 shares for $8000 (minus any commission costs). Your investment return on this stock purchase would be 18%.
Option Purchase. Instead of paying for 100 shares of ABC Stock you decide to purchase an ABC December 70 Call (a single call contract represents the right to buy 100 shares of a stock at the strike price). The premium is $2.20 for the ABC December 70 Call. The expiration date of the option is the third Friday of December and the strike price is $70. The total price of the contract is $2.20 x 100 = $220 (plus commissions which we will not account for in this example).
- Since the strike price of the call option is $70, the stock must rise above $70 before the call option is “in-the-money.” Additionally, since the contract premium is $2.20 per share, the price of ABC would need to rise to $72.20 in order for you to break even on the transaction.
- Two weeks later the stock price has risen to $80. As the value of the underlying stock has increased, the premium on the ABC December 70 Call has also increased to $10.20, making the option contract now worth $10.20 x 100 = $1020. If you sell the option now (closing your position) you would collect the difference between the premium you paid and the current premium $1020-$220 = $800 (minus any commission costs).
- Your investment return on this options transaction would be approximately 364%
- IMPORTANT. Now, suppose you believe the price of the stock will continue rising until the expiration date and you decide to wait to sell or exercise the option. Unfortunately, the stock price drops to $65 on the expiration date. Since this is less than the $70 strike price, the option is “out-of-the-money” and expires worthless. This means you will lose the $220 premium you paid for the options contract, resulting in a 100% investment loss.
Options Risks
Options carry no guarantees, and investors should be aware that it is possible to lose all of your initial investment, and sometimes more. For example:
Option holders (buyers of option contracts) risk the entire amount of the premium paid to purchase the option. If a holder’s option expires “out-of-the-money” the entire premium will be lost.
Option writers (sellers of option contracts) may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses.
UNLIMITED LOSS EXAMPLE: Selling Naked Call Options. Selling a naked call option occurs when an option writer sells a call option without owning the underlying stock. The buyer of the call option has the right to buy the stock at a specified price on or before a specified future date. Since the option writer does not own the underlying stock, if the option buyer exercises the option, the option writer must purchase the shares on the open market to fulfill the option. Since there is no limit to how high a stock’s price may rise, the option writer is exposed to unlimited potential losses.
IMPORTANT: Margin may also be used to trade certain options. Investors should exercise caution before using margin to trade options since it may amplify some of the existing risks with this investment product.
For additional information on options trading and risks you should consider before using this investment strategy please read our investor bulletin “An Introduction to Options.”
Leveraged ETFs
Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Like traditional ETFs, some leveraged ETFs track broad indices, some are sector-specific, and others are linked to commodities, currencies, or some other benchmark. For example, a 2x leveraged S&P 500 ETF seeks to deliver twice the investment return of the S&P 500 Index. This also means that this ETF will lose 2% for every 1% loss in the index. To accomplish their investment objectives, leveraged ETFs use a range of investment strategies through the use of swaps, futures contracts and other derivative instruments.
Leveraged ETFs Risks
Holding longer than one trading day – Most leveraged ETFs “reset” daily, meaning that they are designed to achieve their investment objective on a daily basis. Their performance over longer periods of time may differ significantly from the performance of the underlying index or benchmark during the same period of time.
Underlying Asset Risk – Leveraged ETFs may use complex investment strategies and products to try to meet their stated investment objectives. For example, some of these ETFs may use short positions, swaps, options, future contracts or other derivatives that can expose the ETF to all the risks associated with using those complex investment products. IMPORTANT: When you invest in any ETF your potential losses are generally capped at the amount of money you invest in the ETF. However, if you invest in an ETF using margin your potential losses may exceed the amount of money you invest.
For additional information on Leveraged ETF trading and risks you should consider before using this investment strategy please read our investor bulletin “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.”
Read, Ask, and Learn
If you do not understand an investment strategy or product remember to READ, ASK, AND LEARN. Using leverage to try to increase your investment returns without understanding how leverage works may be risky and costly.
Read and understand agreements and disclosures.
Read your margin agreement and make sure you know how your margin account works and what happens if the price of the securities you buy on margin drops (or rises in the case of short-selling).
Read the “Characteristics and Risks of Standardized Options” disclosure document and make sure you understand the various risks associated with different types of options transactions.
If you do not understand something in these agreements or disclosures, ask your investment firm to provide you with a clear explanation.
Read a leveraged ETF’s prospectus and make sure you understand its investment objectives, principal investment strategies, risks, and costs.
Ask an investment professional. Seek the advice of an investment professional who understands your investment objectives, financial resources and risk tolerance. A good investment professional should understand the leveraged investment products and strategies described above, and should be able to explain whether or how these products and strategies fit with your investment objectives and risk tolerance.
Learn more about an investment strategy or product. Consider taking a class to learn about how these leveraged investment strategies and products work. These classes may allow you to observe the risks of using these strategies and products in a simulated trading environment.
AVOID ANY INVESTMENT STRATEGY OR PRODUCT YOU DO NOT UNDERSTAND.
Additional Resources
Visit Investor.gov, the SEC’s website for individual investors.
Call OIEA at 1-800-732-0330, ask a question using this online form, or email us at Help@SEC.gov.
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This Investor Bulletin represents the views of the staff of the Office of Investor Education and Advocacy. It is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”). The Commission has neither approved nor disapproved its content. This Investor Bulletin, like all staff guidance, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person.
Source: SEC
