Understand Leverage and its implications: Kotak Sec

By Sahaj Agrawal, AVP- Derivatives, Kotak Securities

The ingredients are all in and it’s time to make the most of the recipe, which brings us now to understanding leverage and how to create wealth by choosing your options carefully!

If you have ever taken a loan to finance your car, home education or marriage, you have used some kind of leverage. In simple terms, leverage is borrowing funds in order to increase the return on your invested assets. Financial leverage is produced by borrowing money to create assets or increase returns.

In financial terms, leverage would allow you to invest larger sums of money to achieve your investment goals. Assuming you set aside a certain sum of money every month to invest in equity; your investment would be small and would grow steadily in the long run. When you utilize leverage, you can make a bigger investment and pay back a certain sum every month.

Derivative Markets usually function on leveraging and this can be created through Futures and Options Contracts and Margins. Derivative Contracts are purchased having a set quantity of stock at a pre determined value or Exercise Price. In the Derivative Market, the flexibility to take positions in the Derivative segment by paying a fraction of the exposure taken is referred to as Leverage. 

In a Derivatives Contract, every Contract represents a certain sum of shares of the underlying asset at a fraction of the price. Thus you can control costs and profits on the number of shares at lower operating costs with relatively small amounts of money being invested known as Margins. Leverage hence allows you to exercise control over relatively large amounts of cash / assets and positions with comparatively small levels of invested capital. Leverage offers great flexibility and is what primarily makes Futures or Options Contracts extremely attractive and lucrative.

The smaller the margin in relation to the cash value of the Contract, the higher would be the leverage therein. So for an initial margin of Rs 50,000, you may be able to enter into a short position in a Futures Contract for 5,000 stocks of XYZ Company valued at Rs 5,00,000, which would be then be considered highly leveraged investments. You can also use margins to create the leverage you need to maximise the efficacy of your position.

Here's another example: Let's say you have 50,000 stocks in an Options Contract at the Strike Price 10 trading at Rs. 1. The market price of these shares is Rs 10. The total market value of stocks you hold would be Rs 5,00,000 (50,000 x10) while you would have incurred a much lesser cost of purchase of Rs 50,000. Against investing the full amount to take a certain position, a fraction of the same is invested. Should the market price increase to Rs 12, the market value of the options held by you would increase to Rs. 3. Your profit however would then exponentially increase to Rs 1,00,000. Thus by utilizing Leverage, you can make profits by taking large exposure in Equity Markets.

Leveraging can magnify both gains and losses. Just like you make huge profits, you can also make exponential losses should the price movements be adverse to the position you hold. In addition, you would have to bear the loss of capital; interest that will have to be paid and also interest that has been paid so far which would not have happened had you simply just invested your own money.

Leverage works well for speculative trades and also for hedging especially if you have to keep track of multiple Contracts. It effectively allows you to understand which option you should exercise first to optimise profits. Like with Derivatives, Leverage has to be used with extreme caution and after an in-depth understanding of how the markets are expected to move.

Like Archimedes made us understand, if you know how best to use the lever and if you managed to find one long enough, you can use it to move the world. So go ahead, find your lever and leverage it to the best possible advantage!

Learning Derivatives: Hedgers, Speculators, Arbitrageurs

Understanding Derivatives: Basics of Futures and Options