37 lines
2.5 KiB
Plaintext
37 lines
2.5 KiB
Plaintext
Understanding and Managing Leverage • 175
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also fall to $2.50. If, instead, the value of the underlying security increases
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by $2.50, the value of that allocation will rise to $7.50.
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In a levered portfolio, each $5 allocation uses some proportion of
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capital that is not yours—borrowed in the case of a margin loan and con-
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tingently borrowed in the case of an option. This means that for every
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$1 increase or decrease in the value of the underlying security, the lev-
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ered allocation increases or decreases by more than $1. Leverage, in this
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context, represents the rate at which the value of the allocation increases
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or decreases for every one-unit change in the value of the underlying
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security.
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When thinking about the risk of leverage, we must treat different types
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of losses differently. A realized loss represents a permanent loss of capital—a
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sunk cost for which future returns can offset but never undo. An unrealized
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loss may affect your psychology but not your wealth (unless you need to
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realize the loss to generate cash flow for something else—I talk about this
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in Chapter 11 when I address hedging). For this reason, when we measure
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how much leverage we have when the underlying security declines, we will
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measure it on the basis of how close we are to suffering a realized loss rather
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than on the basis of the unrealized value of the loss. Leverage on the profit
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side will be handled the same way: we will treat our fair value estimate as the
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price at which we will realize a gain. Because the current market price of a
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security may not sit exactly between our fair value estimate and the point at
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which we suffer a realized loss, our upside and downside leverage may be
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different.
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Let’s see how this comes together with an actual example. For this ex-
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ample, I looked at the price of Intel’s (INTC) shares and options when the
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former were trading at $22.99. Let’s say that we want to commit 5 percent
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of our portfolio value to an investment in Intel, which we believe is worth
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$30 per share. For every $100,000 in our portfolio, this would mean buying
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217 shares. This purchase would cost us $4,988.83 (neglecting taxes and
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fees, of course) and would leave us with $11.17 of cash in reserve. After we
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made the buy, the stock price would fluctuate, and depending on what its
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price was at the end of 540 days [I’m using as an investment horizon the
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days to expiration of the longest-tenor long-term equity anticipation secu-
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rities (LEAPS)], the allocation’s profit and loss profile would be represented
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graphically like this: |