Many Australian investors understand the advantages of purchasing stock on margin. For those who don’t, margin lending allows you to leverage your existing portfolio and borrow to buy more. If you already have a portfolio worth $20,000 and you borrow the same amount again to buy more shares, you now have a portfolio worth $40,000. This portfolio is “geared” at 50 per cent. If the value of the shares rises, then you have twice as many shares earning a positive return. Conversely, if your portfolio falls, then your potential losses would be twice as great. Careful stock selection and diversification are therefore of utmost importance.
Gearing can be as high as 70 per cent for those investors prepared to be aggressive, although typically advisers and planners recommend gearing at about the 50% level. This more conservative approach to gearing allows for the potential to “effectively” borrow more, should the value of the shares decline. Remember, if the value of your portfolio falls the borrowing remains the same however, the value of the investor’s capital has diminished, effectively increasing the borrowing.
If you have decided that borrowing to invest is something you’re comfortable with then it’s prudent to shop around. One means of gearing into shares that you probably won’t hear about from a margin lender is to use Low Exercise Price Options (LEPOs). LEPOs provide greater leverage, and at generally lower costs than margin lending.
Low Exercise Price Options (LEPOs) are call options with a 1c exercise price, hence their name, that very closely track the price of the underlying stock or index. Just like margin lending, you only need to put up a small percentage of the price as your initial collateral (or margin). This means your return is geared up according to the margin required. A margin of 10 per cent represents 10 times gearing, 5 per cent is 20 times gearing and so on.
If you compare the margin requirements of LEPOs with the initial collateral required in a margin lending account, you will find that LEPOs may be geared up to a much higher rate than purchasing stock on margin can provide. This can free up your assets for other investments.
The distinguishing feature of LEPOs is that both the buyer and the seller are margined. You both pay or receive margins during the life of the LEPO. Buyers of LEPOs are margined because they have an outstanding obligation to pay the balance of the premium to the writer.
At the end of each trading day, the profit or loss generated from the LEPOs price movement is credited or debited to your account. This eliminates any counter party risk as profits and losses are squared off daily.
The other key factor in comparing LEPOs to a Margin Loan is that the Loan actually costs you money, where as the LEPO will earn you interest. If you have invested $20,000 and then borrowed $20,000 as mentioned above, then you would be required to pay interest on the borrowings at say 7% pa. This is $1,400 for the full year. If you were to enter into a LEPO then you would only be required to pay the initial margin to the OCH, who would then Pay you interest on those funds, currently 4.75% pa. You can clearly see how LEPOs can allow you the freedom to trade without cost or tying up your investment funds, while still achieving the same exposure level.
ASX traded LEPOs can be a valuable alternative to margin lending, so next time you are wanting to gear up an investment speak to your broker and get the lowdown on LEPOs. You can also visit asx.com.au/lepos to get more information.