What Is Leverage In Finance
Table of Contents
In finance, leverage is the practice of borrowing funds to establish bigger positions. Leverage increases the potential for larger returns. But using leverage also increases the risk of loss.
In general, only qualified investors may use leverage when they invest, which they can typically access via a margin account. Margin is a type of loan from a brokerage. Trading on margin is a type of leverage.
As an investor, it’s critical to understand leverage and the additional risks involved if you plan to day trade or make other types of short-term investments.
Key Points
• In investing, leverage refers to the practice of borrowing money to place bigger trades, using a margin loan from a brokerage.
• Thus the use of leverage requires access to a margin account, which is subject to strict rules regarding account minimums and trade requirements.
• While leverage can amplify gains, it also magnifies losses and comes with additional risks and costs.
• Only qualified investors may open a margin account, owing to the higher risk of loss.
• Different types of leverage exist, including financial leverage used by businesses to raise capital, and operating leverage used to analyze fixed and variable costs.
What Is Leverage?
In finance, leverage refers to using a small amount of capital to establish bigger positions, using borrowed funds. This is called trading on margin, and it’s a strategy generally available only to qualified investors.
The use of margin is governed by rules from the Financial Industry Regulatory Authority (FINRA). A margin loan must be backed with cash and other securities, a minimum amount of cash must be maintained in the account, and the margin debt must be paid back with interest, whether investing online or through a traditional brokerage.
Trading With Cash vs. Margin
With a cash brokerage account, an investor can only purchase investments they can cover with cash. If an investor has $5,000 in cash, they can buy $5,000 worth of securities.
A margin account, however, allows qualified investors to borrow funds from the brokerage to purchase securities that are worth more than the cash they have on hand.
In the above example, an investor could borrow up to $5,000, which doubles the amount they can invest (depending on any account restrictions), and place a $10,000 trade.
Although leverage is about borrowing capital in an effort to increase returns when investing in stocks and other securities, if the trade moves in the wrong direction, though, you could suffer a loss — and you’d still have to repay the margin loan, plus interest and fees.
How Leverage Works
In leveraged investing, the leverage is debt that qualified investors use as a part of their investing strategy.
Leverage typically works like this: An investor wants to make a large investment, but doesn’t have enough liquid capital to do it. If they qualify, they use the capital they do have in conjunction with margin (borrowed money) to make a leveraged investment.
If they’re successful, the return on their investment is greater than it would’ve been had they only invested their own capital.
In the event that the investor lost money, they would still have to repay the money they’d borrowed, plus interest and fees.
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Example of Leverage
Let’s say an investor has $10,000 worth of cash and securities in their account. Generally speaking, and assuming they qualify for margin funds, the investor can borrow up to another $10,000, and place a $20,000 trade, though the brokerage firm could impose stricter limits or other restrictions.
That’s because the Federal Reserve’s Regulation T requires a 50% initial margin deposit, minimum, for trading on margin.
Thus, when using margin to buy stocks or other securities, an investor typically can borrow up to 50% of the value of the trade. The cash and securities are collateral for the loan, and the broker also charges interest on the loan, which adds to the cost — and to the risk of loss. (Margin rules can vary, however, depending on the securities being traded and other factors.)
Pros and Cons of Leverage
On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.
| Pros of Leverage | Cons of Leverage |
|---|---|
| Adds buying power | Increased risks and costs |
| Potential to earn greater returns | Leveraged losses are magnified |
| If you qualify, using leverage can be easy | Not all investors qualify for the use of leverage, i.e., margin |
Leverage vs Margin
Leverage is a type of debt. And as noted, margin is a type of leverage that can be used to make investment trades. It’s similar to a line of credit for a brokerage account that qualified investors can access.
Leverage can be used by businesses to expand operations or invest in new equipment or to fund an acquisition. Ideally, the use of leverage will generate additional revenue to cover the cost of the debt.
Leverage vs Margin |
|
|---|---|
| Leverage | Margin |
| A loan from a bank for a specific purpose | A loan from a brokerage for investing in financial instruments |
| Can be used by businesses or individuals | Only qualified investors have access to margin trading |
| Leverage may be used to expand business operations or achieve other goals | Can be used to increase investment buying power |
| Borrowed capital generally must be repaid according to the terms of the loan. | Margin loans must be repaid with interest, and fees. |
Types of Leverage
So far, we’ve mostly discussed leverage as it relates to the financial markets for investors. But there are other types of leverage, too.
Financial Leverage
Financial leverage is used by businesses and organizations as a way to raise money or access additional capital without having to issue additional shares or sell equity. For instance, if a company wants to expand operations, it can take on debt to finance that expansion.
The main ways that a company may do so is by either issuing bonds or by taking out loans. Much like in the leverage example above, this capital injection gives the company more spending power to do what it needs to do, with the expectation that the profits reaped will outweigh the costs of borrowing in the long run.
Operating Leverage
Operating leverage is an accounting measure used by businesses to get an idea of their fixed versus variable costs. When calculating operating leverage, a company looks at its fixed costs as compared to variable costs to get a sense of how the costs of borrowing are affecting its profitability.
Understanding operating leverage helps to evaluate whether a company’s borrowing is profitable (called the debt-to-equity ratio).
Using Borrowed Money to Invest
While many investors utilize margin, it’s also possible to borrow money from an outside source (not your broker or brokerage) to invest with. This may be appealing to some investors who don’t have high enough account balances to meet the thresholds some brokerages have in place to trade on margin.
If an investor doesn’t meet the margin requirements, looking for an outside loan — a personal loan, a home equity loan, etc.— to meet that threshold may be an appealing option.
But, as mentioned, investors will need to consider the additional costs associated with borrowing funds, such as applicable interest rates. So, before doing so, it may be a good idea to consult a financial professional.
Leverage in Personal Finance
The use of leverage also exists in personal finance — not merely in investing. People often leverage their money to make big purchases like cars or homes with auto loans and mortgages.
A mortgage is a fairly simple example of how an individual may use leverage. They’re using their own money for a down payment to buy a home, and then taking out a loan to pay for the rest. The assumption is that the home will accrue value over time, growing their investment.
Leverage in Professional Trading
Professional traders tend to be more aggressive in trying to boost returns, and as such, many consider leverage an incredibly important and potent tool. While the degree to which professional traders use leverage varies from market to market (the stock market versus the foreign exchange market, for example), in general most pro traders are well-versed in leveraging their trades.
This may allow them to significantly increase returns on a given trade. And professionals are given more leeway with margin than the average investor, so they can potentially borrow significantly more than the typical person to trade. Of course, they also have to stomach the risks of doing so, too — because while it may increase returns on a given trade, there is always the possibility that it will not.
Leveraged Products
There are numerous financial products and instruments that investors can use to gain greater exposure to the market, all without increasing their investments, like leveraged ETFs.
Leveraged ETFs
ETFs, or exchange-traded funds, can have leverage baked into them. ETFs are typically baskets of stocks, bonds, or other assets that mirror a relevant index, such as the S&P 500.
Leveraged ETFs, or LETFs, use derivatives so that investors may potentially double (2x), triple (3x) or short (-1) the daily gains or losses of the index. Financial derivatives are contracts whose prices are reliant on an underlying asset.
Leveraged ETFs are highly risky, owing to their use of derivative products.
Volatility and Leverage Ratio
A leverage ratio measures a company’s debt profile, and gives a snapshot of how much debt a company currently has versus its cash flow. Companies can use leverage to increase profitability by expanding operations, etc., but it’s a gamble because that profitability may not materialize as planned.
Knowing the leverage ratio helps company lenders understand just how much debt they’ve taken on, and can also help investors understand whether a company is a potentially risky investment given its debt obligations.
The leverage ratio formula is: total debt / total equity.
Volatility is another element in the mix, and it can be added into the equation to figure out just how volatile an investment may be. That’s important, given how leverage can significantly amplify risk.
The Takeaway
Leverage can help investors, buyers, corporations and others do more with less cash by using borrowed funds. But there are some important considerations to keep in mind when it comes to leverage. In terms of leveraged investing, it has the potential to magnify gains — but also to magnify losses, and increase total costs.
Utilizing leverage and margin as a part of an investing or trading strategy has its pros and cons, and investors should give the risks serious consideration.
If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.
FAQ
What is leverage in simple terms?
In simple terms, the concept of leverage means to use a small amount of force to create a larger outcome. As it relates to finance or investing, this can mean using a small amount of capital to make large or outsized trades or investments.
What is an ordinary example of leverage?
An example of leverage could be a mortgage, or home loan, in which a borrower makes a relatively small down payment and borrows money to purchase a home. They’re making a big financial move with a fraction of the funds necessary to facilitate the transaction, borrowing the remainder.
Why do people want leverage?
Leverage allows investors or traders to make bigger moves or take larger positions in the market with only a relatively small amount of capital. This could lead to larger returns — or larger losses.
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