Leverage Basics

4 Jun

Posted in advanced topics by Roger No Comments

Chances are, if you have done any financial reading, you’ve heard the term ‘leverage’ being tossed around. In truth, leverage is just a fancy word for using borrowed money to purchase investments. The advantage of using leverage is that you can potentially amplify your profits, increasing the return you can get by using your own money alone. The downside is that you could potentially lose much more more money if your investments turn against you, possibly more than you initially put into the investments.

Let’s consider an example to see how this works. You’re considering a particular investment, and trying to decide whether to use leverage or not when you make the initial investment. For this particular hypothetical investment, the maximum amount of leverage you can use is 10 times your investment (that is, for every dollar you invest, you can borrow an additional nine dollars for a total investment of ten dollars). This is more leverage than you can employ with stocks (which is limited to 2x leverage, where half of the money you put up has to be your own), but much less than with FOREX, options, and many other forms of speculation. The interest charged on the borrowed money for our example is going to be 6%, just to have a nice round number, and we’re going to hold the investment for a full year, again, to make the math easier. (In reality, leverage as a technique to enhance your investment returns is usually limited to day traders or others with shorter time frames, but I’m just trying to show a simple example of leverage in action.)

First, let’s look at a good example, one where the investment rises by ten percent, a reasonable amount of profit to expect after one year:

The upside of leverage: enhancing your profits

(Click to view a full-sized image) Here, we can see the advantages of leverage in full effect. If you simply invest $100 without any leverage, you’d generate a handy $10 profit from your investment (notwithstanding any transaction fees for buying and selling the investment). With leverage, though, you’d have invested $1000, ten times as much, and after you paid back the borrowed $900 and the $54 in accrued interest, you’d net a cool $46 in profit (or 46% return on your investment) . (Note: thanks to the interest charged on the borrowed money, you don’t earn ten times the profit as you would earn without leverage; the interest rate is an important consideration when considering leverage.)

So far, so good, right? Leverage leads to greater profits; why not use it? Well, let’s look at the downside of leverage, what happens when the investment goes against you:

The downside of leverage: enhancing returns

The downside of leverage: increasing losses

This time, without using leverage, you would lose $10 when the market value of your investment decreases, a ten percent loss to correspond to a ten percent decrease in the asset value. With leverage, however, the ten percent loss causes you lose your entire $100 stake in the invest. But that’s not all: remember, you need to return not only the $900 you initially borrowed, but also one year’s interest for our particular example. All told, you need to pay back $954; when you add the interest you pay on your leverage to your own losses, you end up losing $154 on your $100 initial investment, for a total investment return of -154%. The only way to really ensure that you make money off of leverage is to be the broker or bank lending out the money for leverage; in both of our situations, the lender made 6% profit on the borrowed $900.

Does this mean you should not use leverage? Maybe; certainly, you should be very, very careful when using leverage. Use it sparingly, if at all; as mentioned, with stocks, you can only borrow an amount equal to your own invested money, and you should probably borrow less than that full amount, anyway. Make sure to monitor your investments closely; if your stake in the investment gets too low, your lender may require that you invest more money or sell some of your holdings (in what’s known as a margin call, which we’ll discuss more tomorrow). Above all, ensure that you don’t take more risk than you need or want to take to meet your goals.

This is just a basic overview of leverage and using borrowed money to make your investments; tomorrow, we’ll cover more on this topic.

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