Leverage is a powerful tool in both investing and trading, allowing individuals and institutions to amplify their potential returns by borrowing money or using other financial instruments. When used wisely, leverage can significantly enhance profits. However, it also carries substantial risks, including the possibility of magnified losses. This article will delve into what leverage is, how it can be used to boost returns, provide example calculations, and outline the risks associated with it.
Part 1: What is Leverage?
Leverage, in the context of finance, refers to the practice of using borrowed money or financial derivatives to increase the potential return on an investment or trade. Essentially, leverage allows investors and traders to control a larger position in an asset than they could with their own capital alone.
How Leverage Works
In traditional investing, you might invest $10,000 to purchase $10,000 worth of stocks. However, when using leverage, you could borrow additional capital to increase the size of your position. For example, if you use 2:1 leverage, you can control $20,000 worth of stocks with just $10,000 of your own money.
Leverage is commonly offered in various forms:
- Margin trading: Borrowing money from a broker to trade stocks, bonds, or other assets.
- Derivatives: Instruments like options and futures contracts allow investors to gain exposure to a large position with a relatively small initial investment.
- Leveraged ETFs: Exchange-Traded Funds (ETFs) that aim to deliver a multiple of the return of a particular index (e.g., 2x or 3x).
Leverage can amplify returns in two ways:
- Positive Leverage: If the investment or trade moves in your favor, your profits are multiplied by the leverage ratio.
- Negative Leverage: If the investment or trade moves against you, your losses are also multiplied.
Part 2: How Leverage Can Increase Returns
Leverage can significantly increase the potential return on an investment or trade. Let’s explore how leverage works in practice with a few example calculations.
Example 1: Leveraging Stocks
Let’s assume you have $10,000 to invest in a stock that is currently trading at $100 per share. Without leverage, you can buy 100 shares. If the stock price rises to $120, your investment would increase in value as follows:
- Initial investment: $10,000 / $100 per share = 100 shares
- Stock price increases to $120: 100 shares × $120 per share = $12,000
- Profit without leverage: $12,000 – $10,000 = $2,000, or a 20% return
Now, let’s assume you use 2:1 leverage. This means you borrow $10,000 from your broker, so you have $20,000 to invest in the same stock. With leverage, you can buy 200 shares instead of 100. Here’s how your investment would look if the stock price increases to $120:
- Initial investment: $20,000 / $100 per share = 200 shares
- Stock price increases to $120: 200 shares × $120 per share = $24,000
- Profit with leverage: $24,000 – $20,000 = $4,000, or a 40% return
As you can see, by using leverage, you’ve doubled your return from 20% to 40%.
Example 2: Leveraging Futures Contracts
Futures contracts are a popular way to use leverage in trading. With futures, you can control a large amount of an asset with a relatively small margin deposit. Let’s say you want to trade crude oil futures, and one contract controls 1,000 barrels of oil.
If the price of crude oil is $50 per barrel, the value of one futures contract is $50,000 (1,000 barrels × $50). However, you don’t need to invest the full $50,000 to control the contract. Instead, you might only need to post an initial margin of 10%, or $5,000.
If the price of crude oil rises to $55 per barrel, the value of your futures contract increases to $55,000 (1,000 barrels × $55). Your profit would be:
- Profit: $55,000 – $50,000 = $5,000
- Return on margin: $5,000 profit / $5,000 margin = 100% return
In this case, a 10% increase in the price of oil resulted in a 100% return on your margin investment.
Part 3: Risks Associated with Leverage
While leverage can amplify gains, it also magnifies losses. It’s essential to understand the risks before using leverage, as it can lead to significant financial losses, including losing more than your initial investment.
Magnified Losses
Just as leverage can increase returns when markets move in your favor, it also magnifies losses when markets move against you. Let’s revisit the stock example from earlier, but this time assume that the stock price drops instead of rising.
- Initial investment with leverage: $20,000 (2:1 leverage, borrowing $10,000)
- Stock price drops from $100 to $80: 200 shares × $80 per share = $16,000
- Loss with leverage: $16,000 – $20,000 = -$4,000, or a 40% loss
Without leverage, your loss would have been only $2,000, or 20%. In this case, leverage doubled your loss.
Margin Calls
When you use margin to invest or trade, your broker will require you to maintain a certain amount of equity in your account. If the value of your account falls below a certain threshold (known as the maintenance margin), your broker will issue a margin call. This means you’ll be required to deposit more money or sell assets to cover the losses.
In the initial example, we used 2:1 leverage to buy 200 shares (instead of 100 shares without leverage) with the stock trading at $100 per share. The total position was worth $20,000 and was funded with $10,000 of own money and $10,000 borrowed from the broker:
- Initial investment: $10,000 (own money)
- Borrowed funds: $10,000
- Total position: $20,000 (200 shares of stock at $100 each)
Let’s assume that the broker requires a maintenance margin of 25%, meaning you must always have equity (your own funds) equivalent to 25% of the total market value of the position. If the value of your equity falls below this threshold, the broker will issue a margin call, requiring you to deposit additional funds or liquidate part of your position.
Imagine the price of our stock drops from $100 to $80 per share. Here’s how our position changes:
- New market value: 200 shares × $80 per share = $16,000
- Loan from broker: $10,000 (this remains unchanged)
- Your equity: $16,000 (market value) – $10,000 (loan) = $6,000
- Equity percentage = $6,000 / $16,000 = 37.5% > 25%
Our equity has fallen to $6,000 and the total position is worth $16,000. This equity percentage is still above the broker’s maintenance margin requirement of 25%, so no margin call is triggered yet.
If the stock price drops further to $60 per share, our position will look like this:
- New market value: 200 shares × $60 per share = $12,000
- Loan from broker: $10,000 (unchanged)
- Your equity: $12,000 (market value) – $10,000 (loan) = $2,000
- Equity percentage = $2,000 / $12,000 = 16.67% < 25%
Our equity has fallen to $2,000 and the total position is worth $12,000. Since the equity percentage has dropped below the broker’s maintenance margin requirement of 25% triggering a margin call from the broker.
When the margin call occurs, your broker will demand that you either:
- Deposit additional funds: You’ll need to add enough cash to your account to bring your equity back to the required maintenance margin level.
- Sell some of your assets: If you don’t deposit additional funds, the broker will liquidate part of your position to restore the required margin.
To avoid liquidation, you need to restore your equity to 25% of the total market value. The current market value of your position is $12,000, so the required equity is 0.25 × $12,000 = $3,000. Since our current equity is $2,000, we need to deposit an additional $1,000 to meet the margin requirement and avoid liquidation. If you fail to deposit the required $1,000, the broker will sell part of your position to restore the margin level. This is called forced liquidation.
Depending on your broker you might not get a margin call first to add additional funds but your position will get auto liquidated when the margin threshold is reached.
Liquidity Risk
Leverage can also exacerbate liquidity risk, particularly in markets that are thinly traded or prone to high volatility. In the event of a market downturn or sudden price swings, investors using leverage may find it difficult to exit their positions without incurring significant losses.
Interest Costs
When you use borrowed money to invest, you’ll typically be required to pay interest on the borrowed amount. Over time, these interest costs can erode your profits. For example, if you borrow $10,000 at an annual interest rate of 5%, you’ll need to pay $500 in interest each year, reducing your overall returns.
Emotional Pressure
Leverage adds an emotional dimension to trading and investing. The potential for large gains and losses can lead to increased stress and the temptation to make rash decisions. This heightened emotional pressure can cause traders to abandon their original strategies and take unnecessary risks, further exacerbating losses.
Part 4: Balancing Leverage and Risk Management
To use leverage responsibly, it’s essential to adopt effective risk management strategies. Here are some key principles to consider when using leverage:
Use Leverage Prudently
Leverage is not suitable for every investor or trader. It’s essential to only use leverage if you fully understand the risks and have a high tolerance for potential losses. It’s also important to avoid over-leveraging, which can lead to substantial losses.
Monitor Your Positions Closely
When using leverage, it’s crucial to monitor your positions regularly. Market conditions can change rapidly, and a position that was initially profitable can quickly become unprofitable if the market moves against you. Keeping a close eye on your leveraged positions allows you to take action quickly if needed.
Diversify Your Portfolio
Diversification is another important risk management strategy when using leverage. By spreading your investments across different asset classes, sectors, or regions, you reduce the impact of a single asset’s poor performance on your overall portfolio.
Understand Your Margin Requirements
Before using leverage, make sure you fully understand your broker’s margin requirements and the consequences of margin calls. Knowing the maintenance margin level will help you avoid unexpected liquidations.
Conclusion
Leverage can be a powerful tool for amplifying investment and trading returns, but it also comes with significant risks. By borrowing money or using financial derivatives, investors can control larger positions and potentially achieve higher returns. However, the downside is that leverage magnifies losses, increases emotional pressure, and exposes traders to the risk of margin calls and forced liquidation.
To use leverage effectively, investors must carefully balance the potential for higher returns with the risks involved. Risk management techniques such as using stop-loss orders, diversifying portfolios, and closely monitoring positions are essential for mitigating the dangers of leverage. Ultimately, leverage should only be used by investors who fully understand the risks and have a clear strategy for managing them. When used prudently, leverage can enhance returns, but without proper risk controls, it can lead to devastating financial consequences.