Leverage

Leverage is a powerful tool that greatly enhances a trader’s ability to profit from financial markets. However, it’s important for traders to understand how it works and use it responsibly to avoid excessive risk and potential losses. Stocks, indices, forex, commodities, and exchange-traded funds (ETFs) are just a few examples of financial markets where leverage can be used. 

 The main idea of leverage is to provide investors, both individual and corporate, with a means to increase their possible returns by accessing borrowed capital. In this article, the details on leverage are outlined: what it is, types of leverage, how leverage affects investment returns, and some real-life examples will be given. We will review several frequently asked questions to view leverage better. 

Leverage

Gearing, also known as leverage, uses borrowed capital to raise the potential return on investment. With credit availability, investors can purchase more than they had initially intended to buy using their own money. The fundamental principle investors will often depend on is that returns on their investments will exceed the cost of obtaining the loan, thus increasing their profit. 

In other words, the debt-equity relationship, in financial terms, would imply that a high leverage ratio means a high level of borrowing for investment to exaggerate profits and losses. The fundamental concept is just like a lever in physics whereby a small amount of force can move an object many times its size similarly; financial leverage enables investors with much smaller funds to hold more significant investments. 

What is leverage? 

Leverage is a term that refers to the trading of financial instruments with borrowed funds. In the trading world, leverage is a crucial tool that allows traders to maximize potential profits while minimizing the capital required to enter a position. Essentially, leverage allows traders to control larger positions with smaller amounts of capital.  

It’s important to note that while leverage can increase potential profits, it also increases potential losses. This is because traders borrow funds to enter a position, and any losses incurred will be magnified by the leverage used. As such, it’s crucial for traders to use leverage  

Understanding leverage 

Instead of directly holding the underlying assets when you trade, you speculate on their price swings to earn a profit. When you use leverage, your broker will put up most of the capital, and you will only need to contribute a small deposit to establish a larger position. 

For instance, opening a position with a broker to trade stocks using leverage would entail borrowing most of the position’s value from that broker, depending on the leverage ratio. No fees will apply regardless of the leverage you use, whether 5x or 20x your initial deposit. 

Trading using leverage is quite alluring because winnings can be massively increased. But leverage has a flip side, and it’s crucial to remember that losses can be doubled rapidly. 

Types of Leverage

Leverage can be divided into several types, each serving different purposes in financial management: 

1. Financial Leverage is the condition wherein one borrows funds to invest in assets, hoping their returns will be higher than the cost of debt. Usually, companies use financial leverage to finance growth initiatives, acquisitions, or any other capital expenditure.

2. Operating Leverage: This refers to the part of a company’s fixed costs in the cost structure. A company with high operating leverage shows very high profits with increased sales, but at a decline, this leaves the company with the burden of fixed costs.

3. Combined Leverage: This shows not only financial and operating leverage but is combined in one measure that gives an all-around view of a company’s risk exposure. It reflects how fixed costs and debt together are affecting overall profitability.

Effects of Leverage on Investment Returns 

Leverage may affect investment returns in many ways, both positively and negatively. Among the significant effects of leverage on investment returns it includes at least one of the following: 

Amplitude of Returns: It refers to the magnitude of returns. While investments are going great, leverage amplifies your profits. Suppose an investor leverages to buy an asset; rental income could help pay the debt but will also result in additional profit due to the appreciation of the property. 

Higher Risk: Higher risk, on the other hand, involves leverage, which amplifies losses. In case of a fall in the value of the investment, the investor may still be committed to repaying the finance and, therefore, may incur losses more significant than their initial investment. 

Volatility: Leveraged investments are typically volatile; small movements in the underlying asset value can result in much larger movements in the investor’s equity. Such volatility is especially acute in leveraged trading instruments, options, and futures. 

Advantages and disadvantages of leverage 

While leverage can offer significant advantages, it also comes with certain risks and disadvantages. 

• One of the main advantages of leverage in trading is the ability to generate higher returns. Financial leverage increases the impact of each dollar you invest. With leverage, traders can earn larger profits than they could with their capital alone.  

• Additionally, leverage can provide greater flexibility in trading, allowing traders to take positions in a wider variety of assets and markets. 

However, leverage also comes with substantial risks.  

• One major disadvantage of leverage is the potential for significant losses. As leverage amplifies the size of a position, even a small decline in the value of an asset can result in substantial losses. Additionally, leverage can increase the risk of margin calls, which require traders to deposit additional funds to cover losses. 
• Another potential disadvantage of leverage in trading is its psychological impact on traders. When using leverage, traders may be more likely to take on excessive risk and make impulsive decisions. This can lead to emotional trading, which is detrimental to long-term success. 

Leverage can be a powerful tool for traders seeking higher returns and taking advantage of market opportunities. However, it is necessary to consider the risks and disadvantages of using leverage, including the potential for significant losses and the psychological impact of trading with borrowed funds. To successfully use leverage in trading, it is essential to have a well-defined trading plan and risk management strategy in place. 

Calculating leverage 

To calculate leverage, traders must first determine their margin requirement. This is the percentage of the total position that must be deposited as collateral to open a trade. For example, if a trader wants to enter a position worth US$10,000 and the margin requirement is 5%, they must deposit US$500 to open the trade.  

Once the margin requirement is determined, traders can calculate their maximum leverage by dividing the total position size by the margin requirement. In the above example, the maximum leverage would be 20:1 (or 5% margin requirement divided into the US$10,000 position size).  

Example of leverage 

• For example, assume a trader wants to buy US$10,000 worth of a particular share. In that case, they may only need to put up US$1,000 of their own funds if their broker offers a leverage ratio of 10:1. This means that the broker is effectively lending the trader the remaining US$9,000 to make the trade.  

           While leverage can be useful for experienced traders, it carries significant risks. If the trade goes against the trader, they could lose more than their initial investment, leading to substantial losses.        Therefore, traders must use leverage wisely and cautiously to avoid undue risks. 

• Being aware of how leverage works in practice, let us consider the following example. 

Investment in Real Estate 

Consider an investor who is seeking to purchase a US$500,000 investment property. Reluctant to pay the entire amount in advance, he instead gears his investment to a 20 percent deposit of US$100,000, and the remaining 80 percent is financed via a US$400,000 loan from any bank at 4 percent per year. 

Scenario 1: Successful Investment 

If the property appreciates to US$ 600,000 after a few years, he can sell his property at a profit. The amount of profit after repayment would be calculated as illustrated below: 

 Sales Price: US$ 600,000 

Loan Repaid: US$ 400,000 

Investor’s Profit: US$600,000 – US$400,000 – US$100,000 = US$100,000 

 Of this amount, in the above example, the investor doubled his money through leverage. 

  Scenario 2: Unsuccessful Investment 

Consider the unsuccessful investment, for example, when the property’s market value falls to US$400,000. For the investor, his calculation would look something like this: 

 Sale Price: US$400,000 

Loan Repayment: US$400,000 

Investor’s Loss: US$400,000 – US$100,000 = -US$100,000 

 In this case, the investor, in addition to losing his money, is at an acute risk of not covering the loan from his rental income. 

Frequently Asked Questions