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Author: DrTarr Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75537  
Subject: Re: Leveraged investing Date: 2/28/2011 9:55 PM
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I well remember Oct'08. We were on a 3 week cruise and the market lost 20% while we were gone.


Leverage:

You saw my position in the earlier post, in moderation use it. I read that other sad story post and not for nothing - he got greedy! Like the old saying goes Bulls make money, bears make money - pigs get slaughtered!!! Sold all his other stocks - put them in one company which was selling for over 100 P/E and then levered up???

SET THE RULES:
Limit the allocation amount in your portfolio! Set the limit and do not go over it! Rebalance out if you exceed either the percent or dollar amount. That takes determination. And is really easy to say - oh ya, I can do that - and then just let it ride one more day!!

I encourage it on a diverse basis. Others have pointed out that funds may have the same volatility as individual equities. Easy to find funds that have more volatility than say a boring utility, but in the case of funds - and to your point, The one stock going down so dramatically - not even to zero just down, down, down did that other guy in and will do us in too. But if that one stock was part of an index it may not have even be that noticable in the index (yes 2008 was a highly correlated pile of doggie dodo) but you get the point. Don't set yourself up with a chance for single point of failure.

Understand - with leverage you go up faster, and you go down faster. What most folks forget or don't realize is that volatility punishes sideways markets: Meaning this:

http://finance.yahoo.com/echarts?s=xle#chart5:symbol=xle;ran...

If the chart did not work - it is a graph of ERX vs XLE Novemr 20, 2008 through July 6, 2010

ERX is a three times leveraged Energy Sector ETF and XLE is an index - so you expect three times the performance. Note that after a year and a half the XLE is up 20% while the ERX is down about 20%. Point being - depending on how you leverage if you are going up and down, down has a bigger influence. and mean reverting volatility is not your friend.


Roll forward in time:
http://finance.yahoo.com/echarts?s=xle#chart8:symbol=xle;ran...

This is the same two instruments but from a bull market view: Notice how ERX is returning more than the three times - infact almost four times, this is the compounding effect.


Again depending on how you lever up. Understand what happens in both the up and down cycles - as well as sideways!! 4% is a pretty big drag!


Don't go on a cruise: Leverage - yes it cuts, faster and deeper than regular. So if you are going to lever up be prepared to monitor a little more frequently. Imagine if you had been on the cruise and instead of 20% it had been 60%. Enough to give you a margin call, that you would not have received cause you are on the cruise and then your broker would have cashed you out! At the low price and when you got back...... after you have done this for a while maybe a short cruise.

Take a cookie every time they pass the plate: If you get into a position and have good hit, take some profits. Example: the average market return is 10.5% a year. And lets say you levered up 2X. What amount would make you happy. If you hit say 20% maybe take a little off the table and find another place. You can get pretty elaborate here - such as watching the underlying index and some stats on that benchmark like P/E or 1 yr forecast and then lever based on those numbers. But take some when they pass it and dont lever based on past performance. Both hard to do!!


Monitor the reason you picked that position - Say you picked Technology cause of its currently low P/E, or Financials because you think there is good growth potential. Montior those items. If technology earnings start to go down do you still want to play with leverage. IF banks start upping the provision for loan losses maybe the growth ain't coming soon - get out.

Decide how you are going to "lever" Straight up borrow the money, use option, or leveraged ETF's. You can do any combo of the above but each has its own benefits and traps. Look at all options (pun intended) both long and short calls and puts...

Enough for now:
1 Limit Allocation
2 Limit Concentration
3 Understand how it works
4 Monitor your position
5 Take a cookie / cut your losses
6 Monitor the fundamentals

And after every exit - honestly tell yourself what went right and what went wrong.

d(lever)/dT
Who would like to see the spreadsheet too! I have one that does simulation on the S&P using 2X leveraged for SWR stuff and that comes out favorable-- most of the time!!! <:g:>
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