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The Basics to Investing in CEFs: Leverage |
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This article is from the Investing Articles: Closed-end Funds series.
A primary use of a margin account is to borrow money with the securities in the account as collateral, usually to invest. Buying on margin, when properly understood, may provide aggressive investors with a strong tool: leverage. To see how this works, consider an example: Investors A and B have $50,000 to invest. Investor A buys 5,000 shares of a $10 CEF. Investor B buys 10,000 shares of the same $10 CEF, but fully margined, that is, he puts up $50,000 and borrows $50,000 more from his broker (with the $50,000 worth of shares as collateral). Suppose, the CEF performs well, and in a reasonable period of time, doubles to $20, at which point both investors sell their shares. Investor A shows a profit of 5000 * $10 = $50,000 or 100%. Investor B, however, shows a profit of 10,000 * $10 = $100,000 or 200%. The reason is simple, with the same amount of money, investor B controlled a larger number of shares (hence, the term, leverage).
However, there is a downside to leverage as well: if the CEF drops to $5 instead of rising to $20, and both investors exit at this point, investor A shows a loss of 5000 * -$5 = -$25,000 or 50%, but investor B is wiped out: 10,000 * -$5 = -$50,000 or 100%. So leverage magnifies your losses as well as your returns.
There are additional factors to be considered: a) Since you borrow funds from your broker, you pay interest (though this is usually less than what a bank or credit card might charge). Interest was not considered in the above example. For an investor who is leveraged to show a profit the security must rise at least over the cost of borrowing. b) Usually brokers impose restrictions on stocks that can be margined (e.g., stocks under $5 are usually not marginable). c) If the market price drops below a certain threshold, the broker may require you to deposit additional money or liquidate a portion of your holdings. This is called a "maintenance call".
Continue to:
CEF, closed-end funds, account, broker, leverage, introduction, financial information, investing, investment tools, reference
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