If you’ve ever traded in the financial markets, chances are you’ve come across the term ‘leverage’. In this blog, we’ll discuss what leverage is, how it is used and its dangers.
Put simply, leverage is the use of borrowed funds to put on positions. Many traders use leverage to increase the size of their position beyond what their trading account balance could furnish.
For example, say you’d like to purchase 100 shares of ITC intraday, whose last traded price (LTP) is say Rs. 200. The margin in your account needed to fund this would be 100 * 200 = Rs. 20,000. However, the broker may provide leverage for intraday trades. For example, you may be allowed to put on this position with just Rs. 10,000, with the broker lending you the remaining Rs. 10,000. This is leverage. The broker has provided leverage of 2:1; you have paid only Rs. 10,000 to control a position worth Rs. 20,000.
Why would one use leverage?
Using leverage can significantly enhance your ROI if the trades you placed end up in your favour. For instance, making Rs 100 on the ITC stock example from above equates to an ROI of 1% (100/10000) if leverage provided by the broker is utilised. However, if you were to pay the entire margin required to take the position and did NOT use the leverage provided by the broker, your ROI would only be 0.5% (100/20000).
What if you’re wrong?
Worst case scenario, if the stock goes to 0, you now owe your broker Rs 10,000. Your total loss will be Rs 20,000; not only have you eroded your capital from Rs 10,000 to 0, but you’re also now indebted to your broker! This is both your risk and the broker’s risk!
So far, using leverage to trade may sound like a no-brainer to you. Former ‘Shark Tank India’ investor Ashneer Grover explained how he used leverage to make a quick buck via the Zomato IPO. BharatPe’s former MD earned a cool Rs 2.25 crore within 8 minutes of Zomato’s massive stock market listing last year. Should retailers follow suit to make some quick, big money with leveraged positions? Absolutely not. Read on!
Let’s analyse Mr Grover’s IPO play a little deeper.
The Zomato IPO as it was
For the IPO, Ashneer paid Rs 5 Cr out of his pocket, while Kotak Mahindra Wealth got him financing for Rs 95 Cr at an annualised interest of 10% for one week (the period for which funds are blocked for an IPO). The leverage offered here is almost 20:1! Grover’s purchase price was Rs. 76, and he sold all his shares at Rs. 136, 8 minutes after listing.
Whenever a company decides to go public, there’s a lot of documents that must be declared. Notably, one of these is the amount of shares available for each category of investors such as QIIs, HNI/NIIs, Retail etc. Mr. Grover falls into the NII or HNI category.
Since the HNI/NII category was oversubscribed by 33 times, Ashneer was allotted Rs 3 Cr worth of shares.
Let’s have a look at the details of the trade and subsequent profit.
A 44% ROI in 8 minutes?! Sign me up…. right? Er, not quite.
Loads of headlines and stories were published about Ashneer’s success, but none highlighted the crazy risk that he took on. What would’ve happened if things didn’t quite go his way?
Let’s look at two scenarios.
Scenario A: Oversubscribed by 2X and Opens 9% lower
For this scenario, let’s assume the IPO was only oversubscribed by 2X and not 33X. Additionally, let’s suppose it lists at a discount similar to what another major unicorn did, PayTM.
PayTM, was a company whose IPO was highly advertised and hyped by promoters and other stakeholders. However, it didn’t live up to the hype at all, despite being hailed as ‘India’s Largest IPO’ at the time. It listed at a 9% discount to the issue price.
So, what would Ashneer’s P&L look like with the aforementioned conditions?
Clearly, the story isn’t half as glamorous anymore. Had Zomato listed at a meagre 9% discount and would’ve only been oversubscribed by 2X, Ashneer would’ve lost 4.7Cr which is a -95% ROI !!!
Scenario B: Oversubscribed by 2X and Opens at Today’s LTP
What is Zomato’s true value? No one really knows. After the IPO frenzy was done with, the market perceived that the IPO price was too high and didn’t accurately reflect the food delivery giant’s business fundamentals.
The stock currently trades at Rs. 47, a 37% decline from Rs 76, where he bought it. What would the numbers look like if the company listed at today’s price and was oversubscribed by 2X?
Some bizarre numbers! In this scenario, not only would he have lost the entire sum he staked, but he would now ALSO OWE Kotak about Rs 14 Cr which includes an interest cost of Rs 18L.
Can you now see the dark side of leverage and its inherent risks?
This was Ashneer’s rationale for all the leverage:
“Of course, I knew of Deepinder (Goyal), and I am a big believer in his ability to persevere and keep building big. Fundamentally, with the pandemic the ticket size of their orders had grown, as people were ordering food from home for 3-4 members in the family, as against single rolls in office, thereby increasing Zomato’s absolute margins.”
This may still be fundamentally true, but the stock price is now 38% lower!
Therefore, when trading with any sort of leverage it is in your best interest to manage your risk and figure out how much you stand to lose in the worst-case scenario! Ashneer played the IPO FOMO game during the bull market and won. More due to the bull market than anything else.
This is called leveraged beta, and NOT alpha 🤠
A similar game in today’s climate would be catastrophic. Does anyone want to try this on Oyo’s IPO? There’s a reason they postponed their IPO 😉😉
Stay tuned for part 2, where we talk about the “implicit” leverage in F&O trading.
