The use of leverage is an investment and trading technique to enhance the return on investments by using borrowed money to fund a portion of the investment costs. Some types of trading have leverage built into the way they work and others give investors a choice of whether or not to use leverage. Leverage must be used with caution. The benefits of leverage turn into large losses if the investor makes poor investment choices.
Multiplying the Power of Capital
Leverage allows investors to increase the buying power of their investment capital. The ability to buy a larger amount of an investment multiplies the return on the invested capital. For example, stock is purchased in a margin account using the 50 percent leverage offered by stock brokers. An investor pays $5,000 to buy $10,000 worth of stock, borrowing the balance from the broker. If the stock increases 10 percent to $11,000, the investor earns $1,000 or 20 percent on the $5,000 invested.
Leveraging Allows Acceptable Profit Levels
Some types of trading require the use of leverage to make the typical price changes in the instrument profitable enough for traders. As examples, currency exchange rates are quoted on 1/100th of a cent and the exchange rate may change less than a penny a day. Buying $100,000 worth of currency to earn a few dollars does not make investment sense. If leverage is used and the trader only puts up $1,000 or $2,000 to make $20 to $50 or more per day, the trade becomes attractive.
The amount of leverage an investment allows is usually indicated by a ratio of the investment amount to the value of the investment. Some examples: Real estate can be purchases with down payments of 10-to-20 percent. This investment has 5-to-1 or 10-to-1 leverage. The maximum margin loan in stocks is 50 percent. Stock investors have 2-to-1 leverage. Day trading stock traders are allowed up to 4-to-1 leverage. Futures contracts have leverage of 10-to-1 up to 40-to-1, depending on the commodity contract. Option trading allows investors to fine tune the leverage from about 3-to-1 up to 100-to-1 or higher. Forex currency trading is limited to 50-to-1 leverage in the U.S.
Dangers of Leverage
The biggest danger of using leverage is to have the investment decrease in value enough to result in a loss greater than the investment amount. Stock margin rules and option trading limit the amount a trader can lose. Other types of leveraged trading can result in losses much larger than the initial investment amount. Traders using leverage must be able to constantly monitor their investment positions and be able to sell out early to avoid mounting losses.
- Investing School: Investing with Leverage (or Margin)
- Get Rich Slowly; Saving and Investing: What is Leverage?; J.D. Roth; April 2007
- "The Complete Guide to Day Trading"; Markus Heitkoetter; 2008