CHAPTER 5 The Secret Financial Tool of the Rich

A GUIDE TO USING LEVERAGE TO INCREASE YOUR ASSETS

The finance world is full of buzzwords that make little sense: “capital” to mean money, “return” to mean profit, and so on. Blame the MBAs of the world. Those in the business of money build a verbal wall around their craft that keeps it mysterious, and thus profitable for them.

One of the least understood words is “leverage.” It’s often used negatively to describe investments that should never have been made or that fail in a spectacular way. It’s a shame, because leverage is a fundamental concept in investing—one everyone should understand and know how to use correctly.

As with any tool, there are good and bad uses for leverage. Knowing your own risk tolerance and financial condition is necessary to take advantage of the power of leverage without overextending yourself.

It’s important, too, to realize that you already use leverage almost every day. When you buy a tank of gas with a credit card and pay it back on payday, that’s leverage. You were able to secure a commodity (a tank full of gasoline) using someone else’s money (the credit card company’s) at zero cost to yourself (assuming that you have a grace period to repay, that you pay within that period, and that your card charges no annual fee).

However briefly, you got access to free money to achieve an economic purpose. That purpose might have been to drive to an important sales meeting—or just to get home for the night. If the former, you actually used that free money to make money indirectly. If it was just to get home, you still technically made money, in the sense that every day you waited to pay the credit card company, it lost interest-earning power on those dollars while you may have earned interest on cash sitting in your bank account.

You did take on the small risk of not paying it back on time, and if you get caught in the typical credit card web of late payments and interest charges, the tables quickly turn against you. Now the credit card company is making money on your lack of foresight, again using leverage.

With that example in mind, what follows is a beginner’s guide to financial leverage, from the most common and pedestrian forms to the more exotic and high risk. While each strategy has its quirks and caveats, they each share a basic premise: using other people’s money to make more money for you.

Tactic 1: Buy a Home

People tend to look at homeownership through rose-colored glasses. They see borrowing money to buy a house as building stability and never really consider the actual mechanics of a home loan. Nevertheless, a mortgage loan is leverage. When else in your life will you borrow 80 percent or more of the value of an appreciating asset and get to use the asset while you pay back the loan? (Cars, in comparison, only depreciate; whatever the resale value of a Honda, it’s far less than what you paid new.)

Let’s say you put down the standard 20 percent on a home valued at $150,000 with a 30-year term at a 4 percent interest rate. You have to pay $30,000 today to secure the loan, but you get to spend $120,000 more.

Your monthly payment will come to $573. Over the 30 years, you will have paid $86,243 in interest payments plus the balance of $120,000.

Wait, you might say, I’m out $206,243 for a home valued at $150,000! Yes, but you also lived in a home for 30 years at a cost that, if you took a fixed loan, never rose above $573 a month. If you had tried to rent a home 30 years ago at $573 a month, inflation would have driven the cost up to $1,396 a month by the end. You also enjoyed mortgage interest and real estate tax breaks in all those intervening years.

Presumably, too, your $150,000 home bought in 1981 would be worth $365,000 today, protecting your cash investment from inflation. The mid-2000s financial-crisis housing crash notwithstanding, a prudent mortgage loan taken over the long term offers a foolproof gain to even the sleepiest of investors.

Tactic 2: Buy Several Homes or Buildings

Knowing how real estate works, you can consider a slightly more adventurous approach: buying more than one home. You lose some of the tax advantages, but a true real estate investor is looking to marry other people’s money—specifically, bank lenders and renters—together to produce an income stream.

The trick is what real estate pros call a “triple net lease,” in which the investor finds a tenant who is willing to take on the three major ownership costs of the property—taxes, insurance, and maintenance—as well as the rent, or pay a rent that covers all costs. Once these items are built into the lease agreement, the property owner is able to pay finance costs back to the lender and keeps any difference free and clear as income.

This is leverage in the purest sense because you are borrowing money from one party and using the money of a renter to pay back the loan. The property might appreciate over time, adding to the total return, but it doesn’t have to. That was the fundamental error of buyers during the housing boom—they counted far too much on appreciation to make things work. True real estate investing is always about cash flow using other people’s money, not buying and selling at a rapid clip.

Of course, experts can make real estate investing sound extremely easy. It is not. You have to do a lot of on-the-ground research and be able to do financial equations on the fly in your head. Before embarking on any kind of leverage-driven investment plan, consider what might happen if things turn south. Leverage, even used prudently, does include risk, and you want a cash cushion set aside before making a leveraged investment, enough to cover three to five years on the associated loan. You’ll want life and disability-income insurance as well to protect your family in a worst-case scenario.

Tactic 3: Buy Stocks on Margin

The remainder of the leverage strategies in this chapter assume that you’re at least conversant with trading and comfortable with analyzing an investment before buying. Proceed with caution.

Buying stock on margin probably has the worst reputation, largely because such buying contributed heavily to the crash of 1929 and the ensuing Great Depression. To do this right, you need to have cash available to cover what are known as “margin calls.” When investors fail to consider the risk of margin calls, they can get wiped out fast.

How does it work? The simple answer is that you invest with money you borrow, usually from a stockbroker. Say you want to buy 100 shares of a stock trading at $10. That would cost you $1,000. Let’s say you don’t have it all—you have half. So you borrow $500 from your broker, put in your $500, buy the shares, and wait. The stock runs to $15. Perfect! You sell and collect $1,500. You pocket the $1,000, having happily doubled your money (your $500 is now $1,000), and pay back your broker his or her $500.

Now imagine the stock sticks at $10 for weeks and weeks—nothing stirring, not a blade of grass moving in the markets, at least for your little investment. You still have high hopes, so you want to hold the position. Your broker, however, is missing his money. Because he will charge you interest in the meantime, it’s helpful if the stock you bought pays a dividend. That helps offset the cost of interest while you wait. Eventually, the stock pops higher and you get out. Nobody got hurt.

Now picture a third scenario: You buy the stock at $10, and it plunges to $5. If you sold it now, you would have $500 but owe the broker $500. You are busted, a 100 percent loss. Scale that up to thousands of shares, and you can begin to appreciate the risk factor.

Here’s where you run the risk of getting a margin call. If the value of the stock falls to less than double the amount of the loan (a 50 percent “debt-to-equity” ratio), your broker could require you to put in more money to bring it back up. For instance, if your stock slips to $8, it is now worth $800. But you owe $500. Your broker will now ask you to put in at least $200 to bring things back to balance. Don’t have it? You then must sell and take the hit.

This point must be emphasized: Margin investing is not the right path for most ordinary investors. If you don’t already have serious investing chops, don’t do it! But for those who understand the risks and use the tactic within reason and prudently, it can be a powerful tool to accelerate returns.

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Tactic 4: Buy Bonds on Margin

Although not a tactic to use during times when bonds are expensive, few investors realize that they can buy bonds on margin.

The margin requirement on stocks is 50 percent—putting up $50,000 allows you to buy $100,000 worth of stocks. On Treasurys, the requirement could be as low as 10 percent, meaning you can control more bonds with a smaller initial investment—at 10 percent, that’s $500,000 worth of bonds on the $50,000 investment. With investment-grade municipal bonds, it’s often 25 percent of the value.

That additional leverage, however, comes with a higher risk: A mere 10 percent decline wipes you out. That’s why such a strategy is usually employed only by pro traders. As we write this in 2016, with interest rates so low, the danger is even higher. If interest rates rise, the prices of bonds will automatically move in the opposite direction. Taking on leverage now to bet that they will go lower is ill advised, to say the least. Keep this strategy in mind for when things change, as they always do.

Options: Financial assets that trade on regulated exchanges just like shares of stock or bonds. They are one of many types of derivatives, which are assets whose prices are derived from the price of another asset. A “call option” gives the buyer the right to buy 100 shares of a specific stock (or ETF, index, etc.) called the underlying stock. A “put option” gives buyers the right to sell 100 shares of the underlying stock at a fixed price over a given time.

Tactic 5: Explore Options Trading

Options trading is even more complex. The very term may have you shaking your head, saying, “No way.” And guess what? That’s totally fine—you could ignore the rest of this chapter and go on with your financial life, no problem.

But for those who are interested in what options can do for an investment portfolio, you’ll want to read on for a couple of ways that you can use options to try to accelerate returns. Nothing too fancy or complicated—here in Tactic 5, we talk about covered calls, where you gain payments on stock you already own, and in Tactic 6, we explain a slightly more aggressive approach in getting “dividends” out of a non-dividend-paying stock.

The simplest explanation of options is that they allow you to control large amounts of assets at a very low cost. By paying a relatively small amount of money, known as a “premium,” you buy the right to purchase a stock at a specific price, let’s say $10. That level, in the contract, is called the “strike price.” If the stock hits the price, you have agreed to buy it at that level.

Here’s the kicker: If the stock exceeds the strike price, you still get it for $10. Say the stock zooms past $10 and heads to $18. You exercise the option, buy it for $10, and immediately sell and make an 80 percent profit minus the premium paid. If the stock never hits $10, well, you lose just the premium.

You also can use options on stocks you already own, writing what are known as “covered calls.” This offers a way to generate income on very large holdings that you wouldn’t ordinarily sell. It’s important to first consider the tax implications of being forced out of a long-term holding. If you have the tax risk covered by trading in a tax-deferred individual retirement account, for example, writing calls can be a good way to increase your returns without putting up another dime in capital.

With the covered call, you sell one call for every 100 shares owned. If you own 100 shares of stock, you sell one call. If you own 500 shares, you can sell five calls.

By selling calls, you receive cash up front. It’s cash you can use immediately for any reason. It’s your compensation for accepting the potential obligation to sell your shares for the strike price. You can save it, buy more shares, or use it to buy put options to protect your portfolio.

Selling calls doesn’t guarantee that you’ll sell your shares. The shares will only be sold if the call buyer exercises, which should happen only if the stock’s price is greater than the strike price at expiration (the option expires in the money) or if a dividend is paid near expiration.

Why must you own the shares? If you sold a call without owning shares, you’re liable to deliver shares for the strike price. Because there’s no limit on how high a stock’s price can rise, you’d have unlimited risk as the stock price rises above the strike. With a covered call, you own the shares, so that upside risk is “covered.”

However, that doesn’t mean the strategy is without risk. Because you’re holding the shares, you have downside risk. The stock’s price will always be far greater than the option premium received—and you own those shares—so you don’t want the price to fall. If you’re ever going to use a covered call strategy, rule number one is to be sure it’s a stock you’re comfortable holding.

New traders wonder why anyone would sell options. Who wants an obligation? First, option sellers receive cash up front. Cash in the pocket counts. Second, obligations aren’t necessarily bad. Investors willing to sell shares aren’t facing an adverse obligation. Instead, they’re receiving cash for something they were going to do anyway. And chances are, if you bought shares, you have the intention of selling them at some time. The difference is that outright stock owners don’t get paid to sell their shares. Covered call writers do.

Let’s see how you can benefit as a covered call writer. Say you own 100 shares of JPMorgan (JPM), trading for $55 in February 2016. The March $55 call was around $4. If you sell one March $55 call for $4, your stock’s cost basis is reduced by that premium. If you just purchased shares for $55, your effective cost is $51. It’s as if you paid $55 for the shares, but received a $4 cash rebate, which reduced your purchase price—and reduced your risk.

That’s if you bought right away. If you purchased the shares months or years earlier, say for $40, your cost basis is lowered to $36.

Regardless of the price paid for the shares, it’s the current price that determines whether you’ll make money. Let’s fast-forward to March expiration and see what happens. At expiration, the stock’s price will be either below $55, exactly $55, or above.

If the price is $55 or below, the call expires worthless. You keep the $4 premium, and you can write another call. Each time you sell a call against your shares, your cost basis is further reduced. Many covered call writers have written their shares into a negative cost basis, which means they received their principal back plus a guaranteed profit—and still own the shares.

By selling the call, you have some downside protection. If JPM falls to $51 at expiration, you break even, since your cost basis is also $51. If you hadn’t sold the call, you’d be down $4, or 7.3 percent. The stock fell $4 but you made $4 from the call, so you’re even. The option helped turn a loss into a flat return.

If the stock price remained at exactly $55 at expiration, the $55 call expires worthless. With a cost basis of $51, you could sell your shares for the current $55 price, which is a $4 unrealized gain on a $51 cost, or 7.8 percent. It may not sound like much, but that’s for one month. If you continually sold monthly calls and the stock price stayed still, you’d have a much larger compounded gain.

By using options, multiplying returns is relatively easy, even if stock prices don’t move. Covered call writers can perform remarkably well in sideways markets.

If the stock’s price is above $55, you’ll get assigned (the call buyer exercises) and sell your shares for the $55 strike. The most money any covered call writer will ever receive is the strike price. Whether the stock price is $55.01 or higher at expiration, you’ll receive $55, which, again, is a 7.8 percent return in one month.

But that’s a return you could easily calculate before entering the trade, which takes a lot of uncertainty out of simply owning shares. Yes, you’ll miss out on additional upside gains if shares had surged to, say, $70, but that’s the price you pay for the certainty of your upside return.

If your shares get “called away” you’ll have to buy more shares if you want to write another covered call the following month for the same stock. Alternatively, since you’ll have cash to invest, it’s an opportunity to buy a different stock.

New option traders believe the risk of the covered call is getting their shares called away. After all, who’d want to sell shares for $55 if they’re worth more in the open market? Covered call writers must realize getting called away still means making a profit—just not as much. Missing out on some reward is not a risk but a missed opportunity. The risk of the covered call is having the stock’s price fall below your breakeven point. Again, that’s why covered call writers must be comfortable holding the shares of stock.

Bid Price and Ask Price: The bid is the price at which you can currently sell options. The asking price is what you’ll pay to buy the option. The price you pay for buying an option (or receive for selling) is called the premium.

So what are the benefits? Outright stock investors need the stock price to rise to make money. Covered call writers can afford to have the stock price rise, fall a small amount, or stay flat—and still make money. Option traders have more ways to make money. Returns are more consistent with fewer portfolio fluctuations.

Does this mean covered call writers are expected to make more money? In the long run, maybe not. That’s because they sell off all rights to shares above the strike price. Over time, covered call writers will miss out on the occasional home runs that are bound to occur. The covered call writer benefits by smaller, but consistent, proceeds—the equivalent of scoring base hits, not home runs.

As a covered call writer, you’re not required to just sit and wait for expiration. Instead, you can buy back (close) the short call at any time for any reason. If JPM’s price stays the same or falls, the $55 call’s value begins to fall. With less time remaining, or because of a lower stock price, it’s not worth as much. If the call’s price falls from $4 to $2 prior to expiration, you can buy it back to get out of the contract. Each time you pay to close out a short call, you’ll increase your cost basis by the purchase price. If you sold for $4 and bought it back for $2, you made only $2 but also have no chance of having your shares called away. It’s as if you never entered the covered call but have now reduced your cost basis by two dollars from $55 to $53.

The covered call is one of the most versatile of option strategies and there are countless variations. You can sell in-the-money calls for more downside protection, and you could sell out-of-the-money calls for greater profits. Each strike represents a different risk-reward profile.

Regardless of your choice of strikes, the covered call strategy provides an opportunity to make money—and reduce risk—that is just not possible for stock buyers.

Tactic 6: Create Dividends via Options

There is another simple strategy for any stock investors who may think they can’t benefit from options. It’s a powerful strategy that can put money in your pocket every month.

Assume you have 100 shares of XYZ Corp., which was trading for $399 on December 31, 2015. You’re planning on holding it for another year, but wish you could generate monthly income. However, XYZ doesn’t pay a dividend. What can you do?

This is where option traders can create dividends even on stocks that don’t pay them. It’s just one of many advantages option traders have over stock traders.

Here’s how it’s done.

First, sell your 100 shares and receive $39,900 cash. Take some of that money and buy one January 2017 $225 call, which let’s say was trading for $178, or $17,800 total. That leaves you with $39,900 – $17,800 = $22,100 cash, on which your broker will pay monthly interest. That acts as your dividend.

Why did we select the $225 call when the stock is trading close to $400? Remember to consider the breakeven point: $225 strike + $178 premium = $403. We’re pushing the stock’s breakeven price just $4 higher from its current level of $399 to $403. Because the breakeven price is only slightly higher than the stock’s current price, there will be very little difference between owning shares versus the $225 call.

However, in exchange, you’re getting more than $22,000 cash to invest. In other words, you’re giving up $4 of future stock price increase in exchange for $22,000 cash plus an insurance policy. The insurance policy is that your maximum risk is reduced to the $18,000 call’s value rather than the nearly $40,000 had you held the shares.

If the stock’s price climbs, you’ll capture 100 percent of those gains, less the $4 you gave up in time value. Of course, future stock gains aren’t certain. The $22,000 cash is. And what if you did this with 10 stocks? That would be $220,000 cash to invest. You’d still capture nearly all the future stock price gains—with less downside risk.

Even if the stock falls, the option should still hold its value. That’s because the $225 strike price is far below the $399 price—shares would need to fall more than 45 percent before the option lost all its intrinsic value.

If your goal is to receive more cash, and you’re willing to give up more upside potential in return, just select a higher strike call. Higher strikes won’t cost as much and will leave you with more cash to invest.

For instance, let’s say the January 2017 $300 call was trading for $114. Buying that call rather than the $225 strike leaves you with $39,900 – $11,400 = $28,500 cash.

There was a tradeoff though. The breakeven point is raised to $300 strike + $114 premium = $414. With the stock’s current price at $399, a $414 breakeven is $15 higher. In exchange for $6,500 more cash today to invest, you’ve sacrificed $15 per share of potential future gains.

This strategy is sometimes called a synthetic dividend. By using options, investors can create a man-made, or synthetic, dividend—even on a non-dividend-paying stock. Even better, you’ll receive monthly rather than quarterly income, which is how most dividends are paid.

Of course, that’s a case where you knew in advance you were going to sell the stock within a year. For a different way of generating income without having to first sell the stock, covered call writing is a more appropriate strategy.

Obstacles are those frightful things you see when you take your eyes off your goal.

—HENRY FORD