Friday, August 13, 2010

Leveraging Amplifies Profit/Loss; Overleveraging Can Be Detrimental

The broad market index is falling during the whole week. As mentioned previously, the portfolio is long the market and therefore the value shrinks at the end of the week. The investment strategy developed for speculative stock trading is subject to the test of real market condition.

The leveraged ETFs in the portfolio slightly exceeds the limit outlined in the trading strategy. The equity stock in the portfolio exceeds the limit outlined in the trading strategy by a larger extent. As a result, there is no cash buffer in the portfolio. It appears that hedging is not enough for current market movement. Although the impact on core investment is confined up to this moment, further downward movement of market will damage the core investment due to margin maintenance requirement in the trading account.

It is not known whether the market is stable at current level or will decline further. Apparently, the portfolio is over invested without enough cash buffer to accommodate market reversal. This is the same mistake made during the financial crisis and should be avoided in the future by keeping with the investment limit outlined in the trading strategy.

The portfolio is under threat of significant loss if the market continues to drop. However, the probability of another big decline seems not high. Therefore the portfolio will wait to see if there is a rebound. After that some of the core investment needs to be liquidated to provide adequate cash buffer for the portfolio and rebuild the hedging tools.

In previous discussions, the trading strategy emphasizes on risk control. The importance of adequate cash buffer for a leveraged trading account is experienced during this week's market decline. Over investing is a major factor for the destruction of the investment portfolio during the financial crisis. If there is enough cash buffer in the account to survive a market dip and rebound, the portfolio can maintain its value. Otherwise the damage to the portfolio is permanent. Following is the scenario for a fully invested margin trading account with calculated figures.

Most stock brokers allow a margin borrowing of 30% to 50% for stocks. The percentage for penny stocks and leveraged ETFs may be higher, i.e. less borrowing. For simplicity of calculation, assume a margin percentage of 33⅓%, i.e. trader can borrow 66⅔% of collateral market value. Also, assume that the initial portfolio value is 100 and the stock drops 33⅓% first and then rises back to original value. For a cash trading account or margin trading account without borrowing, the portfolio remains intact after the dip and rebound.

The scenario for a fully invested margin trading account is different. The net value in the account is 100. With borrowing, the stock value in the account magnifies to 300 and the borrowing is 200. When the stock declines by 33⅓%, the stock value in the account becomes 200. The available borrowing from the collateral becomes 133⅓. Thus the trader is required to pay back the excess borrowing of 200 - 133⅓ = 66⅔. There are two possibilities to achieve this purpose. The first is to deposit additional fund into the account to reduce borrowing. The second, which is most of the case, is to liquidate the collateral. This requires selling of 100 worth of stock, ½ (100/200) of stock shares, at market price to reduce borrowing from 200 to 100. The account holding becomes 100 worth of stock and 100 of borrowing. The net value of the account is zero. Practically, the trader has lost all the principal. When the stock rebounds to original value, the stock value becomes 150 (300 x ½). Since the borrowing is 100, the net value is 50 (150 - 100). Thus the final portfolio value is only half of the original portfolio value.

The above example shows that over leveraging can destroy 50% of the portfolio value for a 33⅓% dip and rebound while a cash trading account or margin trading account without borrowing can preserve the portfolio value.

Since the portfolio is for speculative stock trading, the use of leveraging is considered adequate. However, the trading experience learned from this week's market movement is to maintain adequate cash buffer and hedging for core investment in the portfolio.

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