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Borrowing to buy stocks is risky business

india Updated: Apr 25, 2008 00:14 IST
Arnav Pandya
Arnav Pandya
Hindustan Times
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Tackling leveraged positions is one of the biggest problems faced by investors for several months now. These positions were created because of the easy liquidity in the system, which allowed for such structures. However the collapse in several areas of the equity markets has hit them hard even as they try to recover their situation by limiting losses. There are several things that need to be considered when looking at such positions.

Plan for bad times

The leverage structure gives great returns when times are good. This allows a person to take a position that would otherwise have not been possible, thereby multiplying the gains. Most people do not consider that this has a downside. But when the market falls the losses are also magnified in the same proportion leading to a larger hit than what would be seen otherwise. So it is important that the downside is also considered and planned for by the individual.

Simple leverage

There are different ways of creating a simple leverage and the easiest one involves using margin to trade. In this case the investor puts up only a part of the money required for the trade while the broker usually finances the rest. This allows the person to take a large position resulting in high leverage. The other way in which traditional leverage occurs is by using the derivatives route. Here, with a small amount of money the investor is able to deal in large quantities and can gain or lose in a similar manner.

Other types

This does not mean that the types of leverage are limited. There are other ways in which this can be created. For example there were a lot of people who borrowed on the basis of their mutual fund holdings. The amount that was borrowed against these holdings was then further invested in the market. This created a situation of a super leverage and the problem began when the position became a bit tough.

Due to the loss in value the investor could not liquidate the existing position without incurring a loss. This was the reason why the structure started to spiral out of control for the individual leading to a position where they were faced with large losses. These are the basic risks that are present in a particular situation and a person needs to be very careful while they are creating a certain position.

The author is a certified financial planner