Leverage is using borrowed money to purchase a larger amount of an investment for the same amount of cash. Using leverage is common in real estate investing, but stock market investors can also use leverage to boost their returns.
Terminology
In the stock market the use of leverage is called buying on the margin. An investor who has money or investments in a margin account is allowed to borrow money from the broker to pay for a portion of the cost of stocks.
Function
The Federal Reserve sets margin rules. Currently the rules allow stock investors to borrow up to 50% of the cost to invest in stocks or exchange-traded funds. The margin leverage allows the buyer to purchase twice as much stock for the same amount of cash.
Effects
Buying stock on the margin with leverage can increase the potential gains of the investment. For example, $10,000 is invested in a stock using $5,000 cash from the investor and $5,000 borrowed from the broker. If the stock goes up 10% the gain is $1,000. A $1,000 gain on the $5,000 invested works out to a 20% profit margin.
Potential
Using leverage under the current margin rules can result in a doubling of the profit margin on stocks that rise in value. However, if the stock purchased on the margin decreases in value, the losses are also magnified. A 50% decline on a stock purchased with the maximum leverage would result in a 100% wipeout of the investment.
Warning
The investor equity in an account is the value of the stocks minus the margin loan. If the value of the stocks in the account decline, the broker can ask the investor to deposit more money to maintain a minimum level of investor participation. This minimum equity level is called the margin maintenance requirement and is 33% of the account value. If the margin call is not met, the broker is allowed to sell any securities in the account to pay off the margin loan.
