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Saturday, January 9, 2010

Several ways to extend your exposure to the market

In bear markets no one wants to have much exposure to the markets. That is if you don't feel comfortable in taking short positions. If you like them, it's better to be as much exposed as you could. But even in that case you  usually don't need extra cash but just enough shares from which you could borrow.

In a bull market the more money you put in it, the more you could gain. The problem is that sometimes you don't have enough free cash to input. In times like this one option you may choose is to extend your leverage. A good thing about today's economic world is you don't have always to use your own money to get more share of the market.

N.B. An important notice about leverage is that along with the ability to extend your long positions without adding your own extra cash, leveraging increases the risk of losing all your money. So it should be used carefully and only by persons who know what they are doing.

Leveraging basically means to extend your buying power by some additional cash. A leverage level of 2 to 1 would mean that you operate with twice the money you own and half of that money is yours while the other one is borrowed. For that borrowed part you usually pay interest rate but it gives you the ability to own twice as more quantity of the shares or other type equity as you would own without the additional money. Respectively a leverage level of zero or 1 would mean that you operate only with your own money.

The simplest way to increase your leverage is to use borrowed money. Apart from the any obvious ways to borrow money you could find any of your local banks offering a special deal called "repo deal". You can check some definition of repo deals but basically these deals present a contract on the basis of which you get money that is secured by the shares you own. That way in any case you fail to make your payments the bank could sell your shares in order to return the money it gave you. So in a bear market this could present a very significant risk to your holdings. This could not be the case in a bull market though. Repo deals could be used for short term financing as well as for a long term one. They are a common tool for many corporations, banks or investment vehicles but in some countries and markets could be offered also to individuals.

A more common way to increase your leverage on a developed market is to arrange some level of margin with your broker. According to the level your broker offers you you could be able to extend your buying power significantly. The level vary and you may see a 10% leverage as well as 100% and more. A 10% margin means that your broker would allow you to buy shares for 10% more than the equity you have in your account with them. Respectively a 100% level would increase your buying power by 100%. Usually you pay a little interest on that borrowed money which is quite normal but you should keep it in mind when you calculate your results.

A relatively new way to get an extended exposure to the markets is by trading CFDs. The name comes from "contract for difference" and when you trade them you don't actually buy the underlying stock. A good explanation on what are CFDs will inform you about their nature, what risks and abilities they present and how they could be used. Usually the companies that offer CFD trading will give you access to not only the stock markets but also to Foreign Exchange market (FOREX). With CFDs you could normally get a leverage of 5 to 100 times your initial capital. This means that you could have a buying power of 100 times your own cash, i.e. if you put $1000 in a CFD account you could buy for $100000. This could increase your profits but increases your risk accordingly.

With every type of leverage one should be aware of the higher risk level they all present. The bank credit and the repo deals could present a lower risk than the margin account or CDF trading but there is still a risk. Simply put the risk in leveraging is that you could lose more than you have! On the other hand is the possibility to significantly speed up your profits.

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