How does one lose money when reasonably buying with leverage?

Question

I'm one of the newbie retail investors that this guy (and presumably a lot of his colleagues) seem to hate.

Ironically, my biggest loss was from agreeing with specialists that the recent rally is bogus, and attempting to profit by shorting stock. In April. Thus I learnt a valuable, if costly, lesson on the risk of short-selling: if your target stock doesn't go down soon, it likely never will (†).

What I don't understand is the implication I sense from Chief Hater-of-the-Noobs up there that those who buy on leverage also stand to lose badly. I understand how one can lose all when buying on huge leverage - buy on 10x leverage, stock goes down 10%, your investment is gone. But is this really a risk for those on more reasonable leverage, like 2x or 5x? Can't one simply sit calmly and wait for the prices to recover (†)? Even in the March crash, a lot of companies only went down around 30% in value, so taking a total loss on reasonable leverage doesn't seem that likely.

Is there something that I'm missing?

† My underlying assumption is that, for most stocks, the week/month/year average price does go up eventually.

Answer 1

https://blog.mint.com/investing/the-dangers-of-leverage-and-some-solutions/ explains this pretty well. It's a lot like other risk calculations in that you can get bigger gains with leverage, but losses can also be larger. The other people whose money you're using are also going to want that money back whether you are operating at a gain or a loss.

But wait a minute. Now look at the other side of the leverage equation. If your $50 stock loses three points, you are down $300 and shares are only worth $47. If you used margin and bought 200 shares, the three-point drop takes your value down $600.

Something else also happens here. Your $10,000 investment fell to $9,400, but half of the original, or $5,000, was borrowed and you still have to pay that back. But based on current value of $9,400, you are only allowed to borrow half, or $4,700. So you will get a margin call, a demand for you to deposit $300 more in your account to maintain that 50% ratio between your money and your leveraged money.

Answer 2

You appear to be severely underestimating the risk associated with (a) investing with leverage; and (b) shorting stock. As well, you defend your actions by saying you 'agreed with the specialists', but keep in mind that there is never unanimous agreement over what will happen in the market, and even if someone knew with 75% certainty that a stock will go down, there is still a 25% chance it goes up instead.

Why does leverage increase risk?

Risk in finance is defined as the variance in possible returns. So if your possible return on being right is to double your money, and your possible risk on being wrong is to lose everything (like betting $5 on the flip of a coin), your risk is massive. If your possible return on a simple equity investment is 10% over the course of a year [a high-end estimate of a good stock market return], and your risk of being wrong is -10% over the year [which would be a devastating 1-year return], your variance in outcomes only goes from 90-110%, so you your risk is lower.

But when you borrow money to make that lower-risk investment, look what happens: Assume you invest $50 of your own money, and $50 borrowed money. If the stock goes up 10%, your investment portfolio is worth $110. Because you only used $50 of your own money, your net equity earnings are $10 / $50 = 20%. ie: you have doubled your rate of return from 10% to 20%. If you like, you could immediately pay off your $50 loan and be left with $60, which again shows the 20% earnings. Now assume the same scenario, but the stock drops by 10%. Your total portfolio drops to $90, a loss of $10 off of your $50 personal cash invested (ie: a 20% loss). So the variance in possible return has moved from 90%-110%, to 80%-120%. Your risk has effectively doubled, because half of your investment comes from borrowings.

Now imagine you had 5x leverage, meaning $1 equity for every $5 of borrowed funds. So if you invested $600 in the market, and it dropped by 10%, you would go down to $540 in value. But you would still owe $500! So you will have dropped your $100 equity value down to $40, meaning you would turn a 10% market loss into a 60% personal investment loss!

And every day you wait for the market to recover [which is not guaranteed to happen, particular in a short enough time frame that you can rely on it like this], you have to pay interest costs, meaning at say 5% interest annually, you might add another $25 / year in interest costs, or about $2 / month (which is 2/ 40 = 8% of your current $40 equity value, being lost every month to interest!).

As well, keep in mind that when shorting stock, your risk is technically unlimited - if a $5 stock goes to $15, you will have lost 200% of your original investment value, a risk capped at 100% when traditionally buying stock.

The more you combine these risky strategies, the more your risk increases, it should come as no surprise.

(I did not comment on the margin-call aspect of this, which Freiheit includes in his answer. In short, if your equity drops down so significantly, you likely would need to repay your loans to your broker, whether you want to sell or not.)

Answer 3

You are missing a very important detail about leverage. Leverage requires you not just to get the direction right but also the timing. Let's try some math:

1. Some asset goes down 10% one week then up 12% the next week. You have no leverage. You invested $1,000. You went down to $900 then up to $1,008. You made 0.8% in two weeks. Not too shabby.

2. You do the same thing, but with reasonable 5x leverage. So when the asset went down 10%, you went down 50%. You now have $500. But then when it went up 12%, you went up 60%. You now have $800.

Wait, what?! What happened there? How did the underlying go up 0.8% and your leveraged investment went down 20%? Isn't the leveraged investment supposed to do what the underlying does -- just more so?

It is a common misunderstanding that a leveraged investment does the same thing the underlying does, just more. That is not what a leveraged investment does. (In fact, it's mathematically impossible for it to.) Lots of people don't understand that.

How does one lose money when reasonably buying with leverage?

When you don't understand leverage, don't understand how to rebalance, and time the market badly, you can lose money when reasonably buying with leverage even if you invest in an underlying asset that goes up in value. Really.