The Double-Edged Sword of Leverage
[7 minute read] Leverage is both the most powerful and most dangerous tool in finance. Here's how you can use it to your advantage.
On March 22nd, 2021, Viacom announced a $3 billion share offering. On first impression, this was another run-of-the-mill share offering announcement. No one expected the stock to fall by almost 10% in the next trading day, and then fall another 45% within the next few days. Viacom wasn’t alone. Its peer media company Discovery also saw its stock collapse with the same magnitude in the same timeframe.
How did this happen? A $3 billion share offering is certainly negative news for the stock but it’s not -60% bad. Something in the market broke and it broke hard.
As it turned out, the rapid collapse of both stocks was caused by the implosion of a little known multi-billion dollar family fund called Archegos Capital Management. A small drop in Viacom’s stock price triggered cascading margin calls which resulted in the fund’s prime brokers taking control of all of Archegos’s assets (of which Viacom and Discovery were big holdings) and selling them at any price to recuperate their losses.
In aggregate, it was a margin call of epic proportions that wiped out Achegos’s multi-billion dollar portfolio in just a few days.
Archegos was the personal fund of a quiet but accomplished investor named Bill Hwang. Although Hwang preferred to be a low-profile billionaire, he was certainly not reserved when it came to trading. In fact, he was a reckless maverick.
Despite his recklessness, Bill Hwang was extraordinarily successful for about a year. He rode the pandemic bull market upwards and grew his fund by 24x from $1.5 billion to $36 billion between March 2020 and March 2021.
How did he pull off such a tremendous feat of wealth accumulation? The answer is simple: relentless, unadulterated leverage in the most euphoric bull market in history.
Hwang took $1.5 billion and borrowed $8.5 billion against it for $10 billion of exposure at the onset of the bull market. He kept a similar amount of reckless leverage on billions of dollars throughout the year until it was no longer tenable and his fund blew up. At his peak, he had $160 billion in exposure on just $36 billion in assets. It took just one $3 billion stock offering announcement from Viacom, one of his major holdings, to blow the whole thing up.
The double-edged sword of leverage got Bill Hwang from $1.5 billion to $36 billion in a year. It also took $36 billion from him in just a couple of weeks.
What Makes Leverage So Dangerous?
Put simply, leverage is the use of borrowed money to increase the potential rewards of an investment by increasing the size of the investment.
For example, if you bought $10 worth of General Motors and the stock went up by 10x, you’d have $100. If you had instead leveraged your position by 10x and bought $100 worth of General Motors, you’d have $1000. That’s 10x more than what you could’ve made without leverage.
The mortal edge of leverage is that it could financially ruin you. Back to our example with GM, if you had leveraged your position by 10x but GM fell in price, your lender could get antsy and initiate a margin call. This basically means that your lender will immediately sell all your shares at market price and if the proceeds doesn’t cover what you borrowed, you have to pay extra money to cover the losses that your lender incurred. Margin calls protect the lender at serious cost to the borrower.
The greater the leverage, the less GM’s price needs to drop before a margin call can be triggered. Archegos had 4.5x leverage on $36 billion at the time Viacom announced its ill-fated share offering. A small drop in VIAC was sufficient to margin call Archegos.
Leverage can bring you riches and it can take it all away and more in an instant. This is the mortal edge of leverage that makes it so powerful and dangerous at the same time.
The Right Way to Use Leverage
Leverage may be dangerous but that shouldn’t be the reason to avoid it completely. After all, leverage forms the bedrock of our financial system and, if used properly, is a critical tool for individual investors to grow wealth.
Here are a few different ways to creatively use leverage to your advantage beyond it just being a mechanism for a personal lottery or casino.
Unlocking liquidity
One of the most powerful ways to use leverage is to unlock liquidity from otherwise stagnant assets. For example, if you have equity in your home, or a large stock and bonds portfolio, and you want some extra spending power without selling the assets (thus incurring fees and taxes), you can borrow against them for cash.
This is how many asset-rich individuals like Elon Musk or Jeff Bezos unlock their wealth. Institutions do it too. The repo market, which is often referred to as the plumbing of the financial system, allows institutions to turn large amounts of treasury holdings into cash for a very short period of time.
Rainy day fund
This point is related to unlocking liquidity. Leverage can allow you to be fully invested in the market while still having access to a rainy day fund. Put simply, you can borrow against your investments for some quick rainy day cash.
Many retail brokerages, such as Fidelity and IBKR, have started to allow ordinary investors to borrow against their investments and withdraw the borrowed cash. This is a highly valuable feature that anyone who wants to up their personal finance game should to take advantage of.
Building a real estate portfolio
This is another point related to unlocking liquidity, but in the context of investing in real estate.
The best way to get a real estate portfolio up and running is to borrow against a real estate property that you have equity in (e.g. “take out equity”) and funnel the cash towards the down payment of another property. In this way, you can quickly turn a small real estate portfolio into a large one.
Needless to say, it gets very risky when you’re on the hook for multiple mortgages at a time but ideally, the properties in your portfolio are generating consistent rent income to offset the mortgage payments.
Reducing risk with non-linear probabilities
Finally, here’s a novel idea from yours truly (at least an idea that I haven’t seen anyone talk about) that uses leverage to skew probabilities in your favor when trading.
Consider a scenario where you enter a trade by buying a stock at price A with a price target at price B. Price B is 10% higher than price A. You don’t want to hold this trade for longer than a week.
As you can see from this chart, if the probability distribution for the stock’s price reaching price B within a week looks like this, then you will 5x increase your chances of making the same profit by using leverage to double your position and halving your price target. Put another way, with just a 2x increase in risk, you are 5x more likely to make the same profit. This is objectively a more favorable trade setup than the version without leverage.
The viability of this strategy depends on the actual probability distribution of price movements for an asset. Given that it’s much rarer for stock prices to make large moves over small ones in a given time frame, especially in the absence of major events like earnings calls, I’d reckon this probability distribution often looks like a standard distribution around the current price rather than a linear distribution. As such, the strategy of sizing up a trade with leverage and reducing the price target proportionally should work in your favor most of the time.
Fin
Leverage forms the bedrock for our financial system. It’s also a tool that can unlock tremendous wealth for the individual investor. There are so many ways to creatively use leverage to your advantage and it’s paramount for any ambitious investor to understand and respect the power and pitfalls of leverage.