For a definition, when I search this term on Google, I get this: use borrowed capital for investment.
Leveraging is an extremely powerful tool to make a quick buck. And as I say this, it is an equally powerful tool to destroy wealth as well.
Let me share with you a vicious cycle on how this worked and then destroyed wealth for a fictitious character called Naveen.
Naveen, a millennial, at his first job, started ‘investing’ at a young age of 24. With the help of tips from his friend Pradeep, he carries out his first trade. He opens his Demat account with the help of his friend Pradeep and gets the facility for a 2x leverage.
He invests Rs. 100,000, but buys 2,000 shares of XYZ Ltd. at a price of Rs.100 per share on 16th September 2019.
With the announcement of the corporate tax cuts on 20th September, the stock price jumped up 15.00% in the next 2 days. Happy with the returns earned, he sold of the shares at a price of Rs. 115 per share on 23rd September. Giving him a profit of Rs. 29,769.86 or a whopping 29.77% within a week.
Here’s how he managed it:
Wow! Isn’t it? Absolutely YES!
Naveen, getting excited with this, decides to carry out the next trade in a similar manner, but with a relatively higher risk, and hence negotiates with his broker for more leverage.
He invests Rs. 360,000 to buy 30,000 shares of JKL Ltd. at a price of Rs. 12.00 per share on 25th September 2019. Rs. 210,000 borrowed from the broker for leveraged trade.
The very next day, on 26th September, the price of JKL Ltd. was up by around 4%. He sold off the shares before the end of market hours on 26th September.
Wow again! 9.55% returns in just one day – this seems super interesting.
Getting super excited, on another sure-shot tip from Pradeep, just at the end of trading hours on 26th September, he buys 40,000 shares of ABC Ltd. at Rs. 10 per share taking leverage of Rs. 275,000 from the broker for leveraged trade.
Until 10th October the share price of ABC Ltd. was down to Rs. 8 then, down a significant 20%. As disappointed as he was, Pradeep told him it’s a bad call and he should exit the same.
Isn’t this a common story for a trader? Naveen made Rs. 41,100.82 in the first 2 trades and lost Rs. 81,265.75 in the third, which was supposed to be a sure-shot tip.
If I can borrow a quote from the legendary investor Warren Buffet, he says “When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
Warren Buffet calls it addictive, I call it greed, aren’t both equally harmful for an investor!
If Naveen had lost less than 15% in the third trade, he may have got back to a near no profit no loss situation, but, because of the approx. 2.5x leverage he had taken for a sure-shot tip, the overall demolition of capital was to the tune of almost 60%.
An investor will always be encouraged by brokers & his own greed to take leveraged bets. As much as it is true that leverage can give you high returns, on the flip side, it can lead to big capital losses as well.
Hence, whenever I meet investors, this is one thing I surely tell them, never invest with borrowed funds, especially during volatile times.
Before I end today, have you faced a Naveen like situation?