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Stock Market Guide to Using Leveraged Equities to Double Your Gains

Here's a simple way to learn to invest in stocks using leverage - an essential part of your stock market education.

Let's say we have $10,000 to invest in the share market. And let's say that we can achieve returns of 10% per annum on that money with our investment strategy.

That means after one year we can expect to have earned an extra $1,000.

But suppose we were to borrow an additional $10,000 to add to our own money, and invest the whole $20,000 in the market using the same strategy.

After one year we can now expect to have earned $2,000.

Ignoring borrowing costs, we have now effectively make $2,000 for the year from our $10,000, doubling our return from 10% to 20% per annum.

Using a small amount of money in this way to get a large return is referred to as leverage — and the simplest (but not the only) form of leverage is to borrow money to invest.

By borrowing as much, or more, than you put up yourself, and investing the whole lot, you can effectively double your returns…

 

Margin Loans

There's a special type of loan designed specifically for investing in the share market in this way, known as a “margin loan” . These are interest-only loans secured by shares and they have become increasingly popular in recent years.

You supply only a portion of the money required to purchase the shares, borrowing the rest, but you still get the full benefits of dividends and tax credits applicable to the entire portfolio.

What about borrowing costs?

Interest rates on margin loans are typically 8-9% on the portion of the money you've borrowed, but for individuals these costs should be tax deductible. Note also that most margin lenders will require a minimum deposit on the order of $5,000.

 

How Much Can I Borrow?

The amount you can borrow compared to the total amount invested, is called the “loan-to-value” ratio, or LVR. The higher the LVR, the higher your leverage. The maximum LVR the lender will allow depends on the shares you're investing in, but is usually in the range of 40 - 80%.

For blue chip shares, the lender will typically allow you to borrow more than twice your deposit — but I would recommend keeping the ratio at 1:1 (LVR of 50%) to give you some buffer in case of a margin call.

 

What's a Margin Call?…

Your lender will require you to keep your LVR below the maximum, let's say 70%.

Now, of course, leverage is a double-edged sword. It can magnify losses as well as gains.

Let's say the value of your portfolio falls. That would mean that the loan-to-value ratio — the amount you owe as a percentage of the value of the portfolio — has increased. If the LVR then exceeds the maximum, your lender will demand that you pay back some of your borrowings to keep your level of gearing (or “margin”) to no more than 70%.

To pay back this cash you may be forced to sell some of the existing shares in your portfolio (which means selling the shares after they have just fallen in value — and that is, of course, the worst time to sell).

Alternatively, instead in reducing the “L”, you can increase the “V”. In other words, rather than reducing the amount on loan, you may be able to buy more shares to “top up” the value of your portfolio so that the LVR is less than 70%. But again, this requires you to have the ready cash on hand.

If you borrow only half of the total value of your portfolio, as I recommend, the value of your leveraged equities portfolio would have to fall by nearly 30% before you would be subjected to the dreaded margin call.