What is leverage?
Traders use leverage to get bigger returns from small investments. They only provide part of the capital needed to open a position, but this cash deposit is then magnified – or 'leveraged' – so the profit or loss is based on the total value of the position. If all goes well, the final return 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 trader is required to put up only a fraction of the total position value. The initial deposit is leveraged so the trader get much bigger exposure.
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
‘Leverage’ and ‘margin’ are related but are not the same concepts. When a trader opens a position, s/he deposits an initial investment amount to be leveraged, to maximise trading exposure. In other words, leverage is the increased power to buy or sell financial instruments. Leverage is expressed as a ratio, such as 1:2 or 1:50. Margin, in turn, is the amount of money a trader has to put up and maintain to keep a position open. It operates as a collateral to cover any risks that may arise from trading operations. So, what it boils down to is this: a trader 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, traders increase their market exposure 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 1:400 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. This is based on the amount of equity compared to assets. For instance, if a trader invests with a 1:4 leverage, s/he has to supplement £1,000 and his/her capital will increase by an additional £3,000. 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 leverage – 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 200% 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 cost of leverage over a long timeframe. If an investor can borrow £10,000 at 5% and invest it at 10%, s/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 2,000% 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.