In the world of finance, it’s critical to understand leverage if you plan to day trade or make other types of short-term investments.
In general, leverage means doing a lot with a little. Think about how you may use an actual, physical lever to turn a switch, for instance. The switch itself may be small, and require a turn that’s a quarter of an inch to flip from off to on. But by using a lever — which is much bigger, physically, than the switch itself — the work becomes easier.
So what is leverage in finance? What is leverage trading, and how does this all work? Read on to find out.
What is Leverage?
In finance, leverage refers to using a small amount of capital to do a relatively big amount of work — making big investments with a small amount of money. The rest of the money used to make the investment is borrowed.
Leverage is about borrowing capital to make bigger bets in an effort to increase returns.
How Leverage Works
In leveraged investing, the leverage is debt that investors use as a part of their investing strategy. While it’s easy to think that all debt is bad, in fact it can actually be useful when folded into a specific investing tactic.
Leverage typically works like this: A person or company wants to make an outsized investment, but doesn’t have enough capital to do it. So, they use the capital they do have in conjunction with leverage (borrowed money) to make the investment. If they’re successful, the return on their investment is far greater than it would’ve been had they only invested their own capital.
The risk, of course, is that those returns do not materialize, putting the investor in debt.
Example of Leverage
Here is an example of how leverage may be used:
Let’s say that you found a startup. To get the company off the ground, you take in $10 million from investors, but you want to expand operations fast — hire employees, ramp up research and development efforts, and build out a distribution network.
You can do that with the $10 million, but if you were to borrow another $10 million, you would be able to double your efforts. That would allow you to hire more employees, improve your products faster, and distribute them further and wider.
That $10 million you borrowed is allowing you to do more with less. Of course, you run the risk that the company won’t be able to sustain a quick growth pace, in which case you may not be able to pay back the loan. But if things do work out, you’d be able to grow faster and accrue more value than if you hadn’t taken on any additional debt.
Pros and Cons of Leverage
On the surface, leverage can sound like a great, 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.
What’s important to remember is that there are both pros and cons to a tool like leverage.
|Pros of Leverage||Cons of Leverage|
|Adds buying power||Increased risk|
|Potential to earn greater returns||Leveraged losses are magnified|
|For investors, it’s generally easy to access||It can be more complex than meets the eye|
Leverage vs Margin
Margin is a type of leverage that is specifically tied to use in the financial markets by investors. It is basically like a line of credit for a brokerage or investment account.
Here’s how margin works: An investor has a cash balance, which acts as collateral, and there are interest rates at play, like any other type of loan. With a margin account, investors can tradesome, but not all stocks or other assets on margin.
Using margin, an investor can effectively supercharge their potential gains or losses — which sounds a lot like leverage, too. It’s easy to see how margin and leverage can be conflated. But even if you know what margin trading is and how margin accounts work, it’s important to make sure you know what the differences are. This chart should help.
Leverage vs Margin
|A loan from a bank for a specific purpose||A loan from a brokerage for investing in financial instruments|
|May involve a cash injection to be used for a specific purpose||No cash is exchanged; acts as a line of credit|
|Can be used by businesses or individuals; May take the form of a mortgage or to expand inventory||Can be used to create leverage and increase investment buying power|
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 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 is an accounting measure used by businesses to get an idea of their fixed versus variable costs.
When discussing financial leverage, math needs to be done to figure out whether a company’s borrowing is profitable (called the debt-to-equity ratio). 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.
Leverage trading is using borrowed money to try and increase profits or returns. A company can use leverage investing by purchasing a new factory, allowing it to expand its ability to create products, and as such, increase profitability. An individual investor can borrow money to buy more stocks, increasing their potential returns.
There are a few ways that leverage can be used in investing, either by individuals, or organizations.
Buying on Margin
Margin is a form of leverage, and one that’s available to many investors. Trading on margin means that an investor is using resources borrowed from their brokerage to execute a trade.
Margin buying has its risks, particularly for inexperienced investors. But it is likely one of the most common forms of leverage used in the financial markets.
ETFs, or exchange-traded funds, can also have leverage baked into them. Leveraged ETFs are tradable funds that allow investors to potentially increase their returns by using borrowed money to invest in an underlying index, rather than a single company or stock.
Leveraged ETFs utilize derivatives to increase potential returns for investors.
Using Borrowed Money to Invest
While many investors utilize margin to trade or invest, it’s also possible to simply borrow money from an outside source (not your broker or brokerage) and invest with it. This may be appealing to some investors who don’t have hefty enough balances to meet the thresholds some brokerages have in place to trade on margin.
For example, a platform may require an investor to have a minimum balance of $25,000 in their account before they’ll offer the investor margin trading. If an investor doesn’t have that much, looking for an outside loan — a personal loan, a home equity loan, etc.— to meet that threshold may be an appealing option (though it’s generally a good idea to talk to a financial professional before making any such moves).
Leverage in Personal Finance
The use of leverage also exists in personal finances — 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.
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.
But there are also options contracts that allow investors to add leverage to their positions. Investors can also try their hand in the forex market, which is generally very highly-leveraged. When you look at the tools available to investors, you’ll see that leverage is all over the place.
Volatility and Leverage Ratio
A leverage ratio measures a company’s debt situation, and gives a snapshot of how much debt a company currently has versus its cash flows. Companies can use leverage to increase their profitability by expanding operations, etc., but it’s a gamble because that profitability may not materialize as planned.
Knowing the leverage ratio helps company leaders understand just how much debt they’ve taken on, and can even 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.
Leverage can help investors, buyers, corporations and others do more with less, 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.
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