Understanding Positions and Leverage | CFA Level I Equity Investments

In this lesson, we’ll explore financial positions, particularly short and leveraged positions. We’ll discuss the concept of taking positions in various assets, including securities, commodities, currencies, and real assets, as well as contracts with such underlying assets.

Long and Short Positions

An investor takes a long position when they own an asset, benefiting from its appreciation. On the other hand, a short position is taken when an investor sells assets they don’t own, profiting from a decrease in the asset’s price.

Contracts, such as forwards, futures, swaps, and options, have long and short sides as well. In swaps, each party is long one asset and short the other. For options contracts, the short is the writer of the contract, and the long is the holder of the contract.

An interesting anomaly occurs with put options, where the put holder has a direct long position in the put option contract but an indirect short position on the underlying.

Positions for Hedgers

Hedgers take positions to manage risks rather than profit. For example, an oil producer goes short on oil forwards or futures, while an airline goes long on oil forwards or futures.

Understanding Short Positions in Securities

Short positions are initiated when the short seller simultaneously borrows a security from a lender and sells it. Proceeds from the short sale are left on deposit with the lenders as collateral. The short seller may also be required to deposit additional margin.

Short sellers close their positions by repurchasing the securities and returning them to the security lenders, a process known as short covering.

Leveraged Positions and Margin Purchases

A margin purchase occurs when traders buy securities by borrowing some of the purchase price. The leverage ratio of a margin investment is the value of the asset divided by the value of the equity position.

Formula:

Leverage Ratio = Value of Asset / Value of Equity Position

Using leverage magnifies both gains and losses, referred to as risk from financial leverage.

Maintenance Margin and Margin Calls

To protect themselves from sharp drops in asset value, brokers enforce a maintenance margin requirement on the trader. If the percentage of equity in a margin account falls below the maintenance margin requirement, the investor will receive a margin call.

Margin Call Formula:

Margin Call Price = Initial Purchase Price * (1-Initial Margin) / (1-Maintenance Margin)

Calculating Returns on Leveraged Positions