The importance of leverage in stock market
Leverage, for our purposes, is a way of making a little money does the work of a lot of money. This is important for the independent investor who is primarily interested in building his capital.
In favorable markets, leverage can skyrocket your profits. In unfavorable markets, however, it can multiply your losses. The higher your leverage, the greater will be your risk. The greater your leverage, the greater your potential for getting richer.
Buying calls, warrants, and rights automatically leverages your money, as does buying stocks on margin.
The math of big profits
A quick example of the advantages of leverage is the difference between buying low-and high-priced stocks.
Rate of return on high-priced stock
You purchase 100 shares of Merck at $20 per share. Your investment in the stock is $2,000 (100 shares x $20). The stock increases $2 per share. You sell at the new price of $22 per share. Your rate of return is 10 percent ($2 + $20).
You purchase 400 shares of RJR-Nabisco at $5 per share. Your investment in the stock is $2,000 (400 shares x $20). The stock increases $2 per share. You sell at the new price of $7 per share. Your rate of return is 40 percent ($2 + $5).
Each 1/8 of a point that the lower-priced stock moves represents a higher return on your money than each 1/8 of a point the higher stock moves. A simple understanding of percentages tells you this. The guiding rule in bull markets, then, is to find good, low-priced stocks. Each point they move brings you a higher return on your investment.
But never go for a stock just because it is low priced. Think percent! If a higher-priced stock has a better chance of moving within a given time frame than a lower-priced stock, go for the higher-priced stock.
Going for a higher-priced stock with potential
You have $4,000 to invest. There are many low-priced stocks, but you cannot measure their potential. The lowest-priced stock that you feel will move on the intermediate term is Citicorp. You buy 100 shares of common at $40. The stock climbs to $60 per share within two years. You sell for a profit of $20 per share ($2,000.) That is 50 percent on your money.
I have $4,000 to invest. I want to gamble on a low-priced stock. I like Citicorp, but it's too expensive for me. I want to buy a lot of shares with my $4,000. So, I purchase 500 shares of RJR-Nabisco common at $8 per share. The stock moves to $10 per share after two years, at which time I sell. My profit is $2 per share ($1,000). That is 25 percent on my money.
Clearly the lower-priced stock was not the best buy. Citicorp proved the higher rate of return. The lesson here is that every stock investor must think in percent, not in number of shares. It is not the price of the stock that should be your main interest but, rather, the rate at which it will gain market value.
Look for the lowest price stock that has great potential for a high rate of return. But do not buy a stock just because it is low priced.