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I was learning about options and usage of leverage and I thought about this strategy where from X amount - you invest (X/100 at 100 times leverage) in stock markets and invest the rest (99X/100 ~ X) in a safe liquid mutual fund.

In this way, your mutual fund returns would be nearly the same as fixed deposit bank rates (~8% in India) and you can get your usual returns from the stock market. This way, a stock traders can add this approach to their usual strategy and earn additional returns (~8% from savings rate, arbitrage, etc.) at nearly the same cost.

How would you evaluate it?

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    Investing on leverage (borrowing money to invest) greatly increases you risk. If you x/100 stock leveraged 100 times fall by 10% you lose x/10 which you then have to payback with the rest of you investments. If you stocs nose dive by Y% then they will eat Y% of all you investments (this has the same risk if you were 100% in the market) – sdrawkcabdear Aug 31 '16 at 17:05
  • I am voting to close this question as Too Broad, because you are using many different terms without appearing to understand them. I say this because the question as edited has been answered already but you have not acknowledged the points being raised. To explain further would require in-depth discussion of the following terms: 'Options' 'Hedging' 'Leverage' 'Risk' 'Arbitrage' 'Mutual Fund' and possibly others. Please take time to gain a broader introductory understanding of investing before attempting to recreate a 'new method' of investment. No need to reinvent the wheel. – Grade 'Eh' Bacon Aug 31 '16 at 17:51
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I recall similar strategies when (in the US) interest rates were quite a bit higher than now. The investment company put 75% or so into into a 5 year guaranteed bond, the rest was placed in stock index options. In effect, one had a guaranteed return (less inflation, of course) of principal, and a chance for some market gains especially if it went a lot higher over the next 5 years.

The concept is sound if executed correctly.

  • I fully agree with the content of this answer, but based on comments to my answer below, it seems the asker has some misconceptions about leverage / options / hedging, and may be unaware that this answer assumes that you simply take your original investment amount and split it between stock and bonds. – Grade 'Eh' Bacon Aug 31 '16 at 14:50
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I think you may be confused on terminology here.

Financial leverage is debt that you have taken on, in order to invest. It increases your returns, because it allows you to invest with more money than what you actually own.

Example: If a $1,000 mutual fund investment returns $60 [6%], then you could also take on $1,000 of debt at 3% interest, and earn $120 from both mutual fund investments, paying $30 in interest, leaving you with a net $90 [9% of your initial $1,000].

However, if the mutual fund 'takes a nose dive', and loses money, you still need to pay the $30 interest.

In this way, using financial leverage actually increases your risk. It may provide higher returns, but you have the risk of losing more than just your initial principle amount. In the example above, imagine if the mutual fund you owned collapsed, and was worth nothing. Now, you would have lost $1,000 from the money you invested in the first place, and you would also still owe $1,000 to the bank.

The key take away is that 'no risk' and 'high returns' do not go together. Safe returns right now are hovering around 0% interest rates. If you ever feel you have concocted a mix of options that leaves you with no risk and high returns, check your math again.

As an addendum, if instead what you plan on doing is investing, say, 90% of your money in safe(r) money-market type funds, and 10% in the stock market, then this is a good way to reduce your risk. However, it also reduces your returns, as only a small portion of your portfolio will realize the (typically higher) gains of the stock market. Once again, being safer with your investments leads to less return. That is not necessarily a bad thing; in fact investing some part of your portfolio in interest-earning low risk investments is often advised. 99% is basically the same as 100%, however, so you almost don't benefit at all by investing that 1% in the stock market.

  • Not if you're from India, then interest rate is 6.5%. – SMeznaric Aug 31 '16 at 13:42
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    @SMeznaric The fact that the interest rate is 6.5% at a time when many countries have rates approaching 0%, tells me that India's interest rate is not "risk free". There are two possible reasons for the discrepancy - (1) currency valuation risk (see answer here: money.stackexchange.com/questions/66182/…) ; and/or (2) banking risk (see answer here: money.stackexchange.com/questions/15246/…). – Grade 'Eh' Bacon Aug 31 '16 at 13:54
  • Right, an indeed inflation in India is also around 6% so real interest rate is close to US. Don't know enough about Indian financial compensation schemes to comment on 2. – SMeznaric Aug 31 '16 at 14:02
  • What I am saying is that - almost all of your money is invested in safe avenues - arbitrage, debt MF's, etc. and you invest a hundredth fraction of it into stocks using leveraged options (could even hedge these) then in that case you can at-least expect the typical safe avenue returns and on top of that expect stock market gains. – Mike Aug 31 '16 at 14:28
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    @ralphsol I have added a note to my answer about this - please review the wording of your question; the use of "leverage" as you have it there seems to mean something you didn't intend. – Grade 'Eh' Bacon Aug 31 '16 at 14:35
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There are a number of strategies using options and shares together. One that sells large potential upside gains to assure more consistent medium returns is to "write covered calls". This fairly conservative and is a reasonable entry point into options for an individual investor.

Deeper dive into covered calls

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