Leverage is a concept that some investors and businesses use. In its simplest terms, it is borrowed money that is being used for an investment. This can be helpful for businesses to fund their growth and for investors to increase their returns.
When you use leverage, you are going into debt to acquire some type of asset that will amplify your returns from a project or investment. However, it also amplifies any losses, so it is best to proceed with caution.
How Does Leverage Work?
For investors, leverage is a strategy that is used to borrow capital to improve the potential return on an investment. Traders will only provide part of the needed capital to open a position.
This cash deposit is leveraged, so the profit (or loss) is based on the entire value of the position. If the asset performs well, the return will be greater than the investors initial cash investment. However, if it goes wrong the trader will see losses.
For businesses, leverage is often referred to as the amount of debt utilized to finance an asset. Instead of the business using stock to raise the needed capital they can use debt financing to invest in the business.
What Is an Example?
Imagine that you have $2,000 in capital to invest. Your broker allows leverage of 100:1, meaning you can expose yourself to $200,000 ($2,000 x 100) with just your initial $2,000. Your broker is essentially allowing you to borrow $198,000.
An asset that you are interested in has a price of $10 per unit. Over the course of the day, the price rises to $10.60, and you close the position.
The asset increased $0.60. If you did not use this method and used your $2,000 to buy 200 shares at $10 per unit your profit would be $120 ($0.60 x 200). If you did use the 100:1 ratio, you purchased 20,000 shares with $200,000. Your profit in this case becomes $12,000 ($0.60 x 20,000).
What Is Leverage Trading?
In the above example you saw how this type of trading works. Traders and professional investors take on leverage to increase the money they have to invest. It drastically increases their purchasing power and returns.
What Are Leveraged Products?
Leveraged products are financial instruments that allow you to take a position that is worth more than your initial costs. They all require you to pay the initial portion of the position you plan to open. Leveraged products include Forex trades, stocks, options, commodities, ETFs, and more.
Using Leverage on Margin
When investors are buying on margin it means that they are offering collateral to borrow funds, usually from their broker, to purchase securities. It allows investors greater exposure in securities than what they have from their own cash. Before an investor can begin margin trading they need to open a margin account with their broker.
Why Is Leverage Important?
It is important because it allows investors to significantly increase returns on a particular investment. For companies, it is an important tool that can help them expand business operations.
Types of Leverage
Financial, operating, and combined are the main types of leverage. Each type of leverage comes with a level of risk, but also can be beneficial for companies or traders.
Financial leverage uses borrowed money (debt) as a way to finance the purchase of an asset. Using this method the expectation is that the asset will create income or a capital gain more than the cost of borrowing.
Operating leverage uses fixed operating costs (such as insurance of an asset, maintenance and repairs, property taxes, and depreciation) combined with higher revenues or profit to magnify the upside or downside of the businesses operating profit.
This method is the combination of operating and financial leverage. With combined, businesses can determine the effects of fixed financial charges on operational profits and fixed operating costs and earnings per shares. It allows them to measure the risk of their company.
If the company has operating leverage that is greater than financial leverage, they should look into ways to reduce the amount to maintain their level of risk (and vice versa).
What Is a Leverage Ratio?
Imagine this simplified scenario. You are betting on a coin flip where the odds are 50/50. You bet $50 on heads. If heads wins you will double your money. However, if tails wins you lose $50. If you want to borrow an additional $50 to bet $100 on the flip, you can make (or lose) twice as much. You have leveraged a 2:1 ratio.
How Are Leverage Ratios Used?
These ratios are used by traders and businesses. Brokers will allow traders to utilize up to 100:1, increasing the trading position up to 100 times. But this magnification does not only increase your profit 100-fold, it also magnifies any losses.
How Do You Calculate a Leverage Ratio?
To calculate this ratio you will use this formula:
Financial Leverage = Total Assets / Equity = (Equity + Debt) / Equity
What Is the Difference Between Leverage and Margin?
While leverage and margin are interconnected, they are not one in the same. Leverage refers to the action of taking on debt. Margin is the money borrowed (or debt) that a trader or company uses to invest in the financial assets.
Traders use margins to create leverage, so the two go hand in hand.
Understanding the Complexities
Leverage is a complex tool. The idea of utilizing it to increase your profits can be appealing to many investors, but it comes with risk. Leverage will magnify an investor’s gains and losses. If an investment moves in the wrong direction, a loss will be greater thank you might be willing to take.
That is why this strategy should be avoided by newer investors without the proper guidance from their financial advisor. The right financial advisor can help you create strategies within your portfolio to increase your wealth and provide insight.