More Reader Mail

Another question I recently received was - "what does 30-1 leverage mean?" I would like to address this by first defining leverage. MW defines leverage as the "ability to use credit to enhance your speculative capacity." I would like to elaborate on that a little bit. Borrowing (re: the use of credit) - is only one way to leverage yourself. However, it is probably the simplest example - because people can understand it through the means of their own home - a leveraged investment that all Americans make whether they are aware of it at the time or not.

Example: Johnny decides to buy a new home in Chula Vista, California for $800,000. He manages to round up down payment money of $80,000 and borrows the rest ($720,000) to purchase his new home. That works out to a ratio of about 10% equity / 90% debt from the get go. He is in effect 10-1 leveraged. In other words - for everyone 1% increase in the price of home, he will make 10% on his investment (remember - he has only "invested" the 80K). How is this possible you may ask? (note: this simple example assumes no transaction costs or maintenace costs (re: pmi, property taxes, commissions, etc.)

Well......let's think about it - and assume that his home price rises 10% to $880,000. At that point he has still only invested $80,000, however his total home equity has increased to $160,000 ( original investment (80K) + home price increase (80K) OR asset price (880K ) - total debt (720K)).

For a 10% increase in the asset price - he has made a 100% return on his money - as he is "leveraged 10-1." Of course this math can work in reverse.

The additional important note to make about leverage is that derivatives - of which there are many types - futures, options, etc. - are another financial instrument which enables you to employ high leverage. When I refer to being "leveraged 30-1" in a particular trade - I am definitely referring to owning options contracts as I do not trade on margin at present. This should raise the red flag to two things - 1) volatility can wipe Ben out if he is that leveraged , 2) Ben can make or lose a lot of money very quickly.

In the current trade that I have on in Newmont Mines - the underlying asset was the stock (NEM), and my investment mechanism is the call option - September $37.50 calls. I purchased these calls at $2.20 (10 contracts - with each contract controlling 100 shares = 100*$2.20*10).

The leverage I obtained was not 30-1 on closer reflection - it is actually approximately - 18-1. How did I get that number? I took the price of the stock when I purchased my options - $39.50 and divided it by my purchase price of the option. There are many other ways to conceptualize the idea. Another one way would be to think of it as - as I currently control $40,000 worth of stock with around a $2200 investment. Just as if I owned that stock outright - if its price increases by 10% to $44,000 - I will capture that $4,000 gain with my investment to have $6,200 - so that in effect I have made a 180% return on my investment with a 10% rise in the stock price.

I have seen opportunities to be leveraged as high as 100 or 200-1 just as I have seen more moderate opportunities of 2 or 3-1. The important point of leverage is not that it is a solution which will make you money. All leverage is telling you depending on how you evaluate risk - is that you could potentially risk a smaller portion of your total capital in order to produce the same return as if you had invested all of your money. In order to achieve that benefit you amplify your margin for error however. Additionally - if your idea for the investment was not good in the first place - you will not make any money just because you have leveraged yourself - in fact - you will lose money faster as the stock price decreases.

That is it for today I think - maybe tonight or tomorrow I will follow up with my special report on how we can invest in Warcraft but now the legal books are calling my name and I have to get to work. Have a fantastic weekend and let's make some money together.

Regards,

BG