Leverage

Leverage is borrowing someone else's money to increase your returns. For example, a home mortgage uses leverage because borrowed money is used to acquire an asset. There are many other examples, such as:


 * Stock margin account
 * Hedge fund borrowing against its own investments
 * Derivative security like an option or swap
 * Taking out a cash advance on a credit card and investing the advance

It's called leverage because the effect is to increase both profits and losses, much like a lever in the real world. Financial leverage allows a smaller amount of money to participate in and own profits usually possible only with a larger amount of money. Some options can be considered leveraged investments because they magnify the returns of their underlying securities. Any time you borrow to invest you are leveraging your investment.

Leverage allows the investor to magnify the risk and reward to be more than 100% of the investment. An investor can lose more than the original investment (see below).

Note: If you purchase a futures contract or an  option contract you have not purchased the equity itself, you have purchased a derivative contract on the underlying asset. Buying such a derivative contract has more in common with borrowing the money (from your broker or otherwise) than it does with simply buying the equity without borrowing.

Leverage is calculated as the ratio of the amount you invest (your share of the investment, the "debt") to the amount of the investment (the total invested, the "equity). Examples of leverage are shown below.
 * Leverage = Debt / Equity

Risk
When leverage is used, the risk is increased as well as the reward. Followers of the Bogleheads investment philosophy are strongly discouraged against the use of leverage. The concern is with controlling risk rather than applying strategies to increase it. Leverage should never be used when saving towards retirement, as the level of risk taken with leverage is excessive and can jeopardize retirement savings.

Leveraging investments are only for those willing to accept the possibility that all of their original investment may be lost. As the lender of the borrowed money must be repaid, it is quite probable that the investor will end up owing additional funds. Consequences of significant losses can be severe and are not to be taken lightly. Consider that some forum members associate leverage akin to risks taken by gambling.

Leverage is not always bad. Bank use leverage to run their business. For individual investors, there may be some cases where it makes sense. However, there must always be an exit strategy.

Forms of leverage (investing)
If the investor is always 100% correct, leverage can be profitable. However, each form of leverage has drawbacks. Consider the following examples:

Margin: You borrow money from your broker, but there is interest costs, and you can lose as if you had the larger value invested. For example, you have $25K in your account and "borrow" $25K. In a sell-off you are losing money as if $50K is invested but you only have $25K.

Note that borrowing capital via a margin account incurs interest expenses. In order for a leveraged portfolio to be profitable, the portfolio's returns over the target period must exceed the amount of interest paid to the lender to finance the loaned funds.

Additionally, margin accounts have minimum margin (equity) requirements (usually 30% of the total value of the portfolio's assets, if the portfolio consists entirely of long stock positions). If the account's equity drops below the minimum requirement, the investor faces a margin call: he/she must liquidate assets or add funds to the account until the equity ratio reaches the minimum requirement.

Margin requirements change according to the time of day: regular trading hours versus overnight margin (usually 2x regular trading hours)

A margin call also gives the broker the right to liquidate any or all of the investor's positions, at will and without the investor's approval, until the margin requirement is met. Therefore, unless the investor monitors the account closely, there may be a substantial risk that positions will be liquidated unintentionally, thus realizing unexpected capital gains or losses.

Brokers who offer margin accounts are required to inform investors of their margin requirements and margin rates, and to provide them with standardized materials regarding the risks of buying on margin.

Options: You can buy a 40 Call for $300. If the stock goes up it is as if you own $4000 worth of stock. However you have to be correct on your call over a short time-frame. You pay broker fees as well as time and volatility premiums.

Futures: You must be correct in your call. You can lose more money than you've invested and there are broker/margin fees.

2X, 3X Exchange Traded Funds: The cheapest/simplest alternative. If you are wrong, the position will move against you at 2 to 3 times the normal rate. These also have "tracking error" over longer time-frames and work best in the short-term.

Examples of leveraging
Consider the following two examples. The first example uses a method of borrowing commonly used by stock traders. The second example is hypothetical and intended to show the increased level of risk associated with high amounts of leverage.

Borrowing on margin
Margin borrowing lets you leverage securities you already own to purchase additional securities. With leveraging, you can potentially realize greater investment returns (or greater investment losses).

You purchase $10,000 of stock with $10,000 cash. The stock sells for $11,000 and you have a profit of 10% ($1,000).

Suppose you only had $5,000 of cash. You then borrow $5,000 on margin and sell the stock for $11,000. After paying back the $5,000 borrowed, you end up with a profit of 20% ($1,000).

Instead of gaining $1,000, the stock now loses $1,000. You are left with $4,000 and a loss of 20% ($1,000).

Leverage has not only magnified your gain from 10% to 20%, it magnified your loss as well. Your risk has doubled (leverage factor of 2x). Fees, commissions, interest, and taxes not included.

Cavorite refining corporation
Refer to the table below. You have $50,000 to invest and are absolutely sure that Cavorite Refining Corporation will go to from $50 to $60, so you invest everything at $50/share.

(1) Cavorite Refining increases to $60/share and you receive a profit of $10,000. Skip column (2) for now.

(3) Instead of being satisfied with a $10,000 profit, you buy on emotion and borrow an additional $450,000 which results in an investment of $500,000. A potential profit of $100,000 is waiting for you. This is a leverage of 10x ($500,000 / $50,000).

However... Just before you sell, the supply of Cavorite unexpectedly disappears off the face of the earth. There is nothing left to refine and Cavorite Refining's stock drops to $45/share while it restructures its business.

(4) A sale price of $45/share is enough to payback your lender, but that includes your $50,000. You have been wiped out.

(5) Cavorite Refining learns that it's primary customer, Cavorite Sphere Manufacturing, switches to another supplier and the stock drops to $40/share. Not only have you lost your original investment, but you must find additional cash to pay your lender. As shown in this example, the effects of leverage can be dramatic. If no leverage was used, the losses experienced are limited to the amount of your investment. While a 20% drop is significant (2), it is still a much less significant impact than if leverage was used.

The leverage factor can be seen by comparing the "Stock change %" to the "Net profit or loss %". Without leverage, they are the same. With leverage, the change in profit or loss is magnified by 10x. This is why it's called a "lever".