A safer alternative to margin loans

‘Boost your investment power,' reads a banner on CommSec's website. ‘Borrowing to invest gives you a wider range of investment opportunities and increases your potential returns.'

That's quite the sales pitch and it's 100% true. When the sun is shining, almost nothing will supercharge your returns as much as a margin loan. Unfortunately, this isn't a free lunch, the cost of which is nicely summarised in the risk disclosure statement:

‘We may sell any of or all the financial products supporting your obligations and reduce the amount you owe us; We may sell those financial products without contacting you first' ... ‘What you must pay us is not limited to the value of the financial products supporting your obligations. You must pay us all amounts you owe us even if we reduce the lending ratio of a security' ... [Oh, and by the way] … ‘At any time, we can change the lending ratio without telling you.' 


Margin loans have a tendency to lock in losses at exactly the wrong time, which removes one of the key advantages you have as an investor – a long-term horizon with the ability to weather short-term volatility. If you were leveraged, say, 50% and another financial crisis came along, it's possible you would be completely wiped out, with no dry powder to buy the many opportunities likely to present themselves. For this reason, we strongly recommend investors avoid the use of margin loans and leverage in general.

A (slightly) safer alternative

There's no safe way to leverage your portfolio – any form of gearing will always add risk and amplify your downside. What follows, then, is written with an eye to harm minimisation – it's not a recommendation.

Long-Term Equity Anticipation Securities (LEAPS) are call options you can buy through your broker. These contracts allow you to buy a stock at an agreed price in the future in exchange for an up-front premium. Unlike normal options, they have long-dated expiries of up to a couple of years, and occasionally longer.  

In the right light, they can be viewed as a non-recourse loan for a fixed amount of time, where the interest is paid upfront.

Let's use a real-world example. Say you want to buy Apple stock and its current share price is $175. You can either buy the stock, or you can buy a call option at that strike price for $27, which expires in January 2020. There's no financial difference between the call option and you borrowing the $175 to buy the stock and paying a 7% interest rate ($27/$175 = 15.4%, spread over 26 months).

You have the right to buy Apple for $175 in 2020, whether the stock is at $250 or at $100. If Apple's share price is $100, then your call option expires worthless, but you don't owe the full $75 loss, which would be the case with a margin loan. If the stock is at $250, you will make $48 profit ($250–$175–$27). Given your initial outlay was $27, that's a 78% return instead of the 43% return had you bought the stock – the power of leverage.

LEAPS provide leverage, but the important difference to margin loans and CFDs (don't get me started) is that you pay the downside upfront. The most you can lose is the cost of the option, therefore you can control your loss exposure.

Special situations

To my mind, it may make sense to use LEAPS when two conditions are met. The first is when you can identify a catalyst that will cause your stock's value to be recognised within the two-year option expiry period, such as a takeover. The second condition is when the possibility exists for total loss on your equity investment. This could be because the underlying company itself is highly leveraged, so bankruptcy is a significant risk.

If your potential downside is the same whether you buy the shares or call options (ie a total loss), buying options may offer a more favourable risk-reward ratio. If your choice is between buying a super-risky stock for $100 a share, or five options for $100, and you know that this company is either going to go bankrupt within two years or, say, be refinanced and survive its ordeal (the catalyst), then under the stock purchase you risk $100 for a potential profit of X, whereas under the option purchase, you risk the same $100 but for five times the upside. Alternatively, you could get the same upside by buying just one option, but have roughly a fifth of the potential downside.

If you can tolerate a high level of risk in your portfolio – both mentally and financially – there's nothing wrong with buying speculative stocks that show a lot of upside, but it's especially important to keep a low portfolio weighting. The highest risk stocks on our coverage list have a maximum portfolio weighting of just 1–2%, and we don't recommend allocating more than 10% of your portfolio to high-risk situations collectively. It's those assets with the least downside, not the most upside, that should form the core of your portfolio.