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In technical terms, leverage is the ratio between the amount of money you have in your account and the total size of positions the broker allows you to take.
You’re using leverage every time you enter a position that is worth more than your balance. The maximum ratio can vary between brokers, market regulations, and asset classes — from reasonable 2:1 for equities to monstrous 300:1 in the forex market.
Although leverage allows you to multiply the profits, it multiplies the losses too. Leverage is often referred to as a double-edged sword.
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Leverage Indicates a Debt Load
In practical terms, leverage is the use of borrowed funds to increase position beyond your account balance. You are using debt every time you use leverage, with your balance serving as collateral.
Just like a bank will charge you an interest rate for a loan, the broker will charge you fees for using leverage. Be sure to check the fee structure before using this investing strategy.
Benefits of Using Leverage to Invest
Despite high risks, leverage has few distinctive advantages.
- Magnified returns: The main appeal of leverage is that it amplifies returns. This can be particularly useful in periods of low volatility where market movement might not be large enough to produce meaningful returns.
- Reduced upfront investments: Using a margin account allows you to use different brokers without keeping a lot of money on the platform — practical if you're testing a new service.
- Improved diversification opportunities: Leverage allows you to go after more opportunities at the same time. For example, if you're already fully-invested (unleveraged) but identify a low-risk opportunity, you can use the margin. This scenario requires risk evaluation and management skills.
Calculating Leverage Returns
If you are a short-term speculator, your leverage cost will come in the form of high fees. Yet, if you are constructing a leveraged portfolio, your primary concern will be the cost of debt.
For calculating returns, consider the following formula:
Leveraged Portfolio Return = Return on Investments + [ Debt/Equity + (Return on Investments – Cost of Debt )]
Debt/Equity (D/E) is an important financial ratio that measures a company's financial leverage. You can calculate it by dividing a company's total liabilities by its shareholder equity. Where shareholder equity equals total assets minus total liabilities.
If you're investing in equities, the D/E ratio will be a part of your research process, but do keep in mind that there is no one-size-fits-all approach. While anything under two is considered a good ratio, some sectors like technology will have less leverage ratio. In contrast, others like financials might have a much higher average due to the business structure.
Leverage vs. Margin
While it can be slightly confusing to those new to finance, leverage and margin are both cut from the same cloth.
The difference is that you express leverage as a ratio and margin as a percentage. For example, unleveraged (cash) accounts equal a margin of 100%. You need to have a full size of the position in cash. Meanwhile, a 2:1 leverage equals a 50% margin, while a 10:1 leverage equals a 10% margin.
Having a low margin requirement allows you to use high leverage, but you don’t have to. You can simply trade at a smaller size and follow your risk management plan.
Potential Drawbacks of Leverage
There are also several potential drawbacks of leverage. Here are a few to consider:
- Higher fees: The fees that you pay will be proportional to the size of your position. If you use high leverage on a small account, the fees will quickly add up to a considerable amount.
- Magnified losses: There is no trading strategy out there that avoids losses. There is simply too much unpredictability on the market, and losses (when leveraged) can be devastating. It is not about suffering a single significant loss; it is about what you do after experiencing such a loss. Does it throw you off the plan? If the answer is yes, you might consider limiting or altogether avoiding the leverage.
- Temptation: Amplified returns are very tempting, but they can also lead to overtrading. This increase in volume leads back to paying higher fees and increasing the risk of experiencing a magnified loss.
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Leverage is Situational
As alluring as it is, leverage is best used sporadically and in small doses. Even though magnified returns can be tempting, leverage has been a ruin of many successful investors who got carried away.
While beneficial at times, prolonged exposure to high leverage is asking for trouble. De-leveraging quickly can save you from one of the biggest investors' nightmares — being right but too early.
Frequently Asked Questions
What do you mean by leverage?
Leverage refers to the use of borrowed money or other financial instruments to increase the potential return on an investment. It involves borrowing funds to invest in an asset with the expectation that the returns generated from the asset will exceed the cost of borrowing. This can be done through various methods such as margin trading, options, futures, or using borrowed funds to invest in real estate or other assets. While leverage can potentially magnify profits, it also increases the risk and potential losses. Therefore, it is important for investors to carefully consider the risks and potential rewards before using leverage in their investment strategies.
What is an example of using leverage?
Let’s say that on January 1, you open a margin account with $5,000 and leverage of 3:1. Under these conditions, you now have access to $15,000 of buying power.
After constructing a diversified portfolio, you invest $600 in each of 25 stocks for a total position of $15,000. At the end of the year, your portfolio is 18% up year-to-date — an impressive result.
If you had a cash account and invested only $5,000, your profit would have been $850, but due to the margin, your profit is now $2,550.
However, what if you had a negative year and lost 4%? Because of leverage, your $15,000 of buying power also generates an amplified loss. What would have been a $200 loss for a cash account becomes $600 for a leveraged account. This sum represents 12% of your original investment that is now down to $4,400. In addition, your buying power is now down to $4,400 x 3 = $13,200.
Is leverage good or bad?
Leverage is an amoral concept. On the good side, it can amplify the returns and free up the resources for other purposes. For example, if you have low-risk investment opportunities, you don’t have to keep all the funds in one account with access to leverage.
Yet, if abused, leverage can destroy wealth quickly. One of the most recent examples is Archegos Capital Management that collapsed earlier this year. Due to leverage that reached 8:1 for some positions, a mere sector correction erased over $20 billion in value.