Investment communities over the past few years have taken a lot of heat over the inappropriate use of leverage. This was, after all, what caused so many systemic problems at the biggest domestic banks and was also blamed for causing the economic meltdown that continues to drag on.

Although individuals cannot leverage themselves to the levels that caused a near collapse of the domestic banking system, leverage and use thereof is actually all relative. In fact, it can be worse; if a large financial can only leverage up to a maximum percentage of assets, individuals can leverage themselves as much as they wish, often leveraging more than their assets’ value.

Regardless of one’s view, leverage increases risk exponentially and not proportionately. There are three basic ways that one can create a leveraged position: margin, options or credit. Here are the risks with each.

Margin

Possibly the simplest type of leverage, margin involves using the borrowing value one has in existing securities in order to take positions in other securities. In some cases, the margin value can be as high as 70%, meaning that on a position of $10,000, one can use up to $7,000 to invest elsewhere. However, if the value of the underlying security becomes at risk, positions will be liquidated (or cash injected) in order to meet the margin requirements (e.g. if a fully margined account’s value of $10,000 drops to $9,000, the margin requirement will be closer to $3,000 or a little less than 1/3 of the total account).

Options

Options provide some investors with an opportunity to hedge, speculate or generate income in their portfolios. However, since options expire, they can often leave an investor who entered the position with a lot of wiggle room with a complete loss of invested capital if the option has not performed as expected up to the expiry date.

Credit

Many investors who find the pressure of saving for retirement burdensome will often borrow credit on an unsecured or, quite popularly, on a secured basis in order to infuse a large amount of cash into their investment portfolios (after all, borrowing $400,000 and getting an annual gain of even just 10% will offset the costs, plus how long might it take to save $400,000 in one’s portfolio?). While there are benefits, a lot of people tend to forget that borrowing to invest requires monthly payments. If the investment loses its value, the debt remains (a 20% loss to the investment does not come with a corresponding write-down of 20% on the mortgage, loan, or line of credit). A lot of investors find it difficult to manage their cash flow when debt payments are required and the asset value of their investments has not kept pace with the compounded debt.

Unquestionably using leverage can certainly help people achieve their investment goals. However the risks are tremendous and must be clearly thought out before engaging in such strategies.

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Chris has more than 17 years of financial services experience. He currently manages several bedding related websites, including one about the Best Queen Size Mattress at BestQueenSizeMattress.com and another about where to find a Novaform Mattress Sale at NovaformMattressSale.com.