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 |
|
|---|---|
| Leverage | 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
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 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 Investing
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.
Leveraged ETFs
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.
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.
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.
The Takeaway
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.
If you have the experience and risk tolerance and are ready to try out trading on margin for yourself, SoFi can help. With a SoFi margin account, you can increase your buying power, take advantage of more investment opportunities, and potentially increase your returns.
Photo credit: iStock/StockRocket
*Borrow at 8.50%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
SOIN1121471
