Making Leverage Your Friend

Includes: AAPL, CHK, GRPN
by: George Acs

Remember 1987? I do. Ah, 1987. Hated it!

I was still young. Our first child was barely a year old, the Mets did not repeat their world championship season and Alan Greenspan was entering into his second year as Chairman of the Federal Reserve.

Oh yeah. The stock market crashed. I nearly forgot about that, although I remember exactly where I was when I found out. On the slowest moving elevator in the New York City Municipal Hospital system, on my way to my 13th floor office, listening to the overhead radio piped into the elevator. The elevator radio was meant to help people forget how agonizingly slow the elevator was, but on that day, listening to the news made the wait until I could get out to call my broker the most agonizing ride of my life.

But why remember the crash of 1987, especially since most people are drawing modern day parallels to the dot com days. What are the parallels of 1987 to the 21st century?

Well, there are some. From an historical perspective, the stock market began repeating its 1987 ways as then new Federal Reserve Chairman Ben Bernanke was entering into his second year of tenure, precisely as occurred during his predecessor's second year. At the time lots of people were scared and selling stocks, especially those darn Europeans. Based on the past two weeks, that seems to be a familiar theme.

Of course, all of that occurring during Bernanke's early days of tenure was just a prelude to what many hope is correctly referred to as the "Correction of a Lifetime" that saw its bottom hit in March 2009.

For me, the negative parallels end right there. Fortunately, I've learned a few things from the experiences. You see, back in October of 1987 all of my money was invested in stocks. I didn't really have any discretionary money, as it was all earmarked to help us live the "American Dream." Big mistake using every last cent and not putting any aside. Another big mistake was the use of margin, a simple way to achieve a two to one leveraging of your money.

But at the time, how could you say no to the offer of cheap money, doubling up on your shares and then doubling up on your profits?

Obviously the answer is that you just can't resist that kind of scenario.

My wife and I were home shopping every single weekend looking for that perfect place for our newly expanded family. Any and all money that we were saving would immediately be put into our investments. And why not? The paper profits kept accumulating.

The plan? Find the perfect house, cash out our growing portfolio, make that 20 percent down payment, have cash to spare for furniture and, decorations and live happily ever after. Well, it didn't exactly work out like that. Well, it almost did.

You can probably guess where I'm going with this. Just as we found the perfect home, the market crashed. Through that modern miracle of leverage, in the form of margin, I and others in the same boat crashed an additional floor. We saw our portfolio value drop like a rock and that happened without even a single speculative stock in the portfolio. I even had the good fortune of holding the single largest percent loser of the year, L.F. Rothschild. Something like 97%!!! Nice time for an honored and respected 200 year old investment house to call it quits.


If we would have found the house a week earlier or maybe just a few months later, life would have been a lot different. And by different, I mean less stressful. By less stressful, I mean better.

We both really wanted that house. We had spent six months looking and the real estate market was hot. Who knew when we would find another dream house within our price range? The only problem? Our portfolio was now worth a whole lot less and I didn't really want to sell. With the exception of Rothschild, it was a good solid portfolio, but it wasn't built to withstand a shock to the foundation.

The use of leverage twisted my arm and I had to sell to meet margin calls. We took the losses. I cringed. I swallowed hard. Sucked down a tear or two and then swore that I would never invest anything other than my discretionary money and never do so with borrowed money. Of course, as it turned out, at that time I really didn't have any discretionary money. It was all earmarked for life's necessities.

What did we end up doing? I still cringe thinking about it, although I'm no longer sucking down any tears. 25 years will dull some of your senses and emotions. I cashed out a 403b. My precious retirement pushed off that much further on top of that obscene 10 percent penalty. And the taxes. Oh the taxes.

I had to beg the IRS for a payment plan. The IRS agent said "no" to my initial request. But, upon getting ready to hang up the telephone, the agent told me his name. As if I really cared. But, he had the same obscure last name as a past work acquaintance of mine, whose home I had visited to pay respects following the death of his mother some three years earlier.

Although I had not seen him since then, I asked the agent if he had a relative named Julian. Funny thing. It was his son. And coincidences of all coincidences, it was his house that I had visited to pay my respects to Julian's mother - the IRS agent's wife. Suddenly, Julian's father found a way, a relatively painless way, to pay back the taxes.

Leverage was anything but a friend. In fact, it was nearly the death of me. But then death came to my rescue.

So, as it turned out, we bought the house and moved and stayed for about eight years. Remember that list of dreams we had, though? We almost achieved everything. We did live happily ever after, albeit without much new furniture. Of course, there's also that visually scarred child who wandered into our backyard and caught a Sunday morning glimpse of me through the sliding glass doors for which we couldn't afford shades. But that's the price we and society paid for investing every last cent and then leveraging away the future.

I learned a lot from the crash of 1987. Don't invest money that you can't afford to lose. Don't invest money if there's even the slightest chance that you'll need it in the short-term. Set money aside. Don't use every last cent to achieve your investing dreams, just in case a better bargain comes along tomorrow. Also, even if you think that no one is around on a Sunday morning, wear some clothes.

Interestingly, the housing market didn't learn about the dangers of leverage. What had been a maximum of five to one leverage in 1987 had morphed into twenty to one or more by 1994. I wonder how that ended up working out?

And real estate always appreciates. Right?

One other lesson I learned in those years came when trying to sell a home in New York in 1994 during a real estate slump. The very fact that it can be referred to as a "slump" is enough of an indicator that prices aren't always appreciating. We took that lesson to heart when making the next purchase and didn't fall into the ultra-leveraged products that were available.

My father who was a Holocaust survivor and who had escaped Communist Hungary in the middle of the night through a land mined field with his wife and then very young son always said "It's a free country" when referring to the United States. I had a choice. Back in 1987 I don't believe the expression "between a rock and a hard place" had taken hold yet. But that would have described it well. I had a choice and took it. But the choice to use leverage left me with no choice. That became a sure way to guarantee stock market losses. The last time I looked, that was not my primary objective in buying stocks. Maybe it's yours, after all, it is a free country. But it's not my choice.

So what are the parallels to 1987, besides Greenspan and Bernanke's length of tenure? For me there really are none, except for just one very important thing.

That one thing is leverage. No, I don't use it, but I make my life much easier by enabling other people to use it. No, I don't lend out money, I'm talking about real leverage, although not quite on the level of MF Global or some other infamous players.

In the world of investing there are many forms of life. One of those forms is the options contract buyer. Imagine the incredible pull of an option, especially if you're pre-disposed toward a life of greed. Put up a few dollars to make a fistful. Forget about the boring life of buy and hold. Just trade in and out and count the dough as you drown in the growing pile of cash.

I've written and commented many times on "greed." My use of margin was an example of greed and it got me into trouble.

Since then, I've learned to take advantage of the greedy. It's so simple, although it is a form of greed itself, albeit lesser in magnitude. After all, someone has to sell those avarice driven option buyers their tools of destruction. Why not me? Or you? Why not get something in return for selling the right to someone to buy your stock from you (or sell it to you in the case of having sold a Put contract)? Why not take a small premium in exchange. That's the very money that they were hoping to leverage up many times fold.

When you're possessed by greed you tend to overlook the data, which clearly indicates that most option contracts expire worthless. For the lucky few who catch a tail wind at just the right time there can be larger than life gains. For the ones on top of each and every move in the underlying shares, there may be interim gains, as well.

I look at selling calls on my shares as renting those shares out. But instead of renting them to a nice family of four, I'm renting them to someone who wants to set up a meth lab. The chances are pretty good that meth lab will explode fairly soon and then I'll be in a position to rent it out to another meth lab magnate wannabe, who sees riches in such an existence.

That may be an exaggeration, but under what circumstances would someone be willing to pay $3.05 for the right to purchase shares of Apple (NASDAQ:AAPL) at $550, when shares are trading at $546.08 and with only two days left in the life of the options contract? That's an especially apt question when there is no news scheduled in the next two days. To me, that seems to be an unreasonable risk, but I'd be more than happy to enable such risk taking.

In the case of an embattled company, such as Chesapeake Energy (NYSE:CHK) with positive and negative rumors swirling, perhaps it's a bit easier to understand why someone might offer to pay $0.45 for a $14 call option, as Chesapeake closed at $14.04 with two days until expiration. Similarly, the same rationale can explain why the $14 put could be purchased for $0.42.

Either way, there's a chance that some additional news will come forth, but it's purely a guess as to whether that news will be positive or negative for shares of Chesapeake. Given the overwhelmingly convincing volume on the put side, the supposition must be that the news, if any, will be negative, yet what are they smoking in that pipe to be paying such a large premium for just two days of play time? The value of those options will erode quite rapidly with even a slight move in the wrong direction.

Groupon (NASDAQ:GRPN)? Everyone's favorite whipping boy has numbers just like Chesapeake, except that it closed at $13.05. Yet it is offering Chesapeake like premiums, despite having put its earnings news behind it two days ago.

But in this case the call volume was signaling a strong bullish sentiment, as best as anyone could guess.

Again, for me, in the face of such overwhelming conviction, I can easily justify selling those $14 calls in Chesapeake and selling $13 Groupon puts, thereby enabling unbridled greed on someone else's part.

These days I've learned not to have every last cent invested in case of an emergency. But with most of life's predictable expenses now a thing of the past, I consider an emergency to be an unexpected opportunity to buy a stock at a bargain price. Additionally, now if I close a position at a loss I do so only if I believe my money has a better opportunity elsewhere. Not because I was leveraged into that position.

Leverage was a false friend at one time, but now that it's someone else's false friend, we get along just great.

Disclosure: I am long CHK, GRPN.