What is leverage?
Looking for a leverage definition? It's the use of borrowed money to magnify – or 'leverage' – a small cash investment into a much larger market position in assets of all kinds. Investors use leverage to try to get bigger returns. If all goes well, the final return minus what you owe could be much greater than your initial cash stake. But if it all goes wrong, then so could your losses.
Where have you heard about leverage?
People often talk about leverage as a way of gaining a large exposure to a market with a small outlay. It’s built into some financial products such as options and other derivatives, and Contracts for Difference (CFDs) are well-suited to leveraged trading.
A separate definition of leverage refers to the size of a company’s debts compared with its equity. If a company, a property or an investment is described as ‘highly leveraged’, it means that item or entity has more debt than equity.
Lots of talk about ‘what is leverage’ comes in the context of discussions about the 2007-09 financial crisis, where leverage was a big issue. It got a bad name when it became closely associated with risky behaviour that helped cause the crash, but its reputation has since recovered somewhat.
What you need to know about leverage…
What is leverage, then, and how is it applied in the trading environment? Leverage is an investment model in which the investor is required to put up only a fraction of the total value of the position they wish to take. The provider of the leveraged product is lending the balance.
The size of this small cash stake, known as a margin payment, varies with the types of assets and markets in which you want to trade. A deep, liquid and relatively calm market will require a smaller margin, perhaps 5 or 7% of the value of the position, while a volatile market will see traders asked for more margin, perhaps 10% or more. Margin rates can also vary according to the regulatory rules in the country in which your account is based.
Leverage and margin
Note that leverage and margin aren’t the same, though they are related as both involve borrowing. While leverage refers to the act of taking on debt, margin is a form of debt or borrowed money that’s used to invest in other financial instruments. A margin account enables an investor to borrow money from a broker for a fixed interest rate to buy securities, options or futures contracts in the hope or expectation of getting significantly higher returns. So, what it boils down to is this: an investor can use margin to create leverage.
There are all sorts of leveraged products and uses for them in a range of different asset classes:
- In the stock market, investors can add leverage to their portfolios using futures contracts, margin loans and options. For example, rather than investing £10,000 in a company's stock, you could invest £10,000 in options contracts – which would leave you controlling far more shares.
- Leverage opportunities also exist in the bond market. Here, investors can borrow money at the lower short-term rate and invest it at the significantly higher long-term rate, potentially enabling them to profit from the difference between the two.
- Foreign exchange is a particularly highly leveraged market, with some brokers offering leverage of 400:1 and more.
- Investors can also access leverage indirectly, by investing in companies that use leverage to finance their growth. Companies often use debt financing to invest in new operations that ultimately enable them to add value for shareholders. A balance sheet analysis will reveal which companies do this.
Leverage ratio and volatility
Leveraged investments have what’s known as a leverage ratio based on the amount of equity compared to assets. For instance, if an investor supplements £1,000 with £3,000 of borrowed capital, he creates an investment with four times the leverage. If the underlying investment subsequently gains 10%, the equity in this four-times leveraged investment should therefore increase by 40%. But it’s important to note that the leverage ratio doesn't take account of the cost of debt – it’s just a form of shorthand calculation.
You can also multiply the volatility of the underlying assets by the leverage ratio to find the volatility of the equity. A four-times leveraged investment will have four times the volatility of the same unleveraged investment – which illustrates how leverage amplifies risk.
How leverage works
Let’s consider an example of how leverage might work for you. Imagine you want to buy 1,000 Omnicorp shares that are currently trading at £1 each. This would cost you a total of £1,000. If the shares then go up by 20p a share, you could sell out of your position at £1,200 and make a profit of £200 or 20%.
But if on the other hand you buy the Omnicorp shares using leverage, you only need to put down a margin, and still retain the full exposure. If the initial margin requirement is 10%, you would pay 10% x £1 x 1,000, which is £100. And if the share price rises to £1.20 you still make the same £200 profit as if you’d bought the shares unleveraged. The difference is that in this case there’s a 100% return on your investment compared to just 20% in the first scenario, because with leverage you only had to put down £100.
Benefits of leverage
So the successful use of leveraged products can be very profitable for an investor. The main benefit of financial leverage is that it frees up capital and enables you to take a far larger position than with a direct holding. In this way you can make maximum use of your capital, maybe investing in a range of assets instead of just one or two.
Moreover, big profits can accrue when assets in a leveraged investment compound at a higher rate than the debt over a long timeframe. If an investor can borrow £10,000 at 5% and invest it at 10%, he can make the difference between the investment gains and the interest (£500) as long as the opportunity is available. Such an investment compounded for 10 years will generate £9,648.
Downside of leverage
The downside of financial leverage is that you don’t enjoy the benefit of full ownership of the security. And if the investment moves against you, the loss is far greater than it would have been if the investment hadn’t been leveraged. As is well known, excessive use of financial leverage was one of the main factors that led to the US financial crisis of 2007-09.
To illustrate the potential dangers of leverage, a real estate investor who uses down payments of £20,000 to buy 10 homes valued at £200,000 each would get into trouble if the value of the properties fell to £160,000 each. In this scenario, the buyer’s potential loss of £400,000 would be 200% of the original investment sum. The buyer would also have to keep making mortgage and insurance payments – which could see the losses spiralling quickly. So leverage amplifies losses, just as it amplifies gains.
Find out more about leverage…
If you want to explore leverage and margin further, our extensive glossary has insightful definitions for a number of key terms such as margin, equity, derivative and contract for difference.
Leverage continues to be a hot topic in investment circles, and this article on Nasdaq.com advises caution, stating: ‘The need of the hour is to choose stocks prudently, avoiding those that carry high debt loads… So, the crux of safe investment lies in identifying low leverage stocks.’
You will of course, make your own judgment after weighing up all the pros and cons of financial leverage.