Cash on Cash Returns in Stock Plays

Most first think of a cash on cash return in real estate or a leveraged buyout through a private equity company, but with the number of methods for obtaining margin exploding, understanding your cash on cash return is paramount to deciphering which margin opportunities to exploit.

Cash on Cash Return 101

Cash on cash return is a very simple concept, but one that should be thoroughly understood before trading with margin. Where you can easily find your total return on investment by taking the current value of the investment divided by the total initial investment, the cash on cash return calculation requires an additional step.

Cash on cash return calculates the return only on the amount of cash that is used to make a transaction. Therefore, if a trader were to put up $1000 at 10% margin, he or she would have effectively borrowed $9,000. If the investment purchased with this borrowed cash were to rise to $12,000, the investment would have achieved a total return on investment of 20%. However, as it pertains to the individual trader, the 20% return is heavily understated.

Because the trader put up only 10% of the cost or $1,000, the actual return for the trader is $2,000, or 200%. This figure is the cash on cash return, the total cash profit divided by total outlay.

Practical Application of the Cash on Cash Return

One of the most applicable circumstances in which an investor needs to know the cash on cash return is when developing a new trading strategy, automated or otherwise. In creating this new strategy, a trader should also back test and forward test its effectiveness, as well as take notes about how the strategy could be modified and improved.

If, for example, a trader develops a system that generates a positive return and never once drops more than 8% from top to bottom, the system can be used for greater cash on cash return. If the total loss is never more than 8%, it is safe to assume the trader could then use 20% margin and increase performance, bulk the cash on cash return, and lose at most 40% of the account balance at any one time.

If originally that trading strategy showcased 3.6% annual returns, a safe level of margin at 20% would allow for 18% annually, a far better return than 3.6%, which is roughly the standard for “risk-free” investments.

Points of Consideration

It is important to note that the cash on cash computation does not immediately account for additional risk of drawdown and margin calls, a problem best mitigated by the helpful guidance of a risk management tool such as the Sharpe Ratio. However, the cash on cash return can be useful as an input to the Sharpe Ratio, and it is an excellent tool to determine whether a particular trade, strategy, or other investment is worth additional consideration.

Finally, the cash on cash return ratio helps make immediately visible the costs of carry. If one were to invest without leverage in a strategy that provided 3.6% annual returns, would it be worth additional leverage if the cost to borrow was 2% per year? $10,000 invested at 3.6% is $360, whereas a $50,000 investment of which $40,000 is borrowed at a cost 2%, provides only a $1000 per year return, a higher cash on cash return, but a lower total return.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
Day Trading Simulator provides the ability to simulate day trading 24 hours a day from anywhere in the world. TradingSim provides tick by tick data for...

Send this article to a friend.

Enter multiple addresses on separate lines or separate them with commas.