LEVERAGE

What is Leverage?

Leverage is an investment strategy used by banks, individuals, analysts, etc of using borrowed money such as borrowed capital in order to increase the potential of the expected returns of an investment. However, leverage can not only potentially increase your returns but it could also increase your losses.

Investors use leverage in order to multiply their buying power in the market, therefore it can be viewed as a multiplier of money.

Leverage in Investments and CFDs

The concept of leverage is used both by investors and companies. In each scenario, the leverage term differs. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments, including options, futures, margin accounts, and CFDs. 

Investors who are not comfortable using leverage directly have a variety of ways to access leverage indirectly. They can invest in companies that use leverage in the normal course of their business to finance or expand operations—without increasing their outlay.

For example, when trading CFDs on assets or indices you can use the leverage provided by the platform to maximize potential profits. Let’s assume that you want to open a Buy position on the Nasdaq index at $15,000 to $15,200. Let’s say that if Nasdaq does increase you will make a theoretical profit of $100. However, if you use the leverage of 5 your profits can potentially multiply to $500 and vice versa.  This is called a 1:5 margin (leverage 5x) but in real life, it can be even higher depending on your broker.

Leverage in Businesses

Leverage can also refer to the amount of debt a firm uses to finance its assets. Leverage is the use of debt (borrowed capital) in order to undertake investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out. When one refers to a company, property, or investment as “highly leveraged,” it means that the item has more debt than equity. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.

Pros and Cons of Leverage

Leverage is a multi-faceted, complex tool and it should be treated like one. Beginners should make sure they understand what leverage is before touching it. Since leverage magnifies both gains and losses, an investor who uses leverage to make an investment should be careful. Iffor example, the investment moves the other direction the loss could be much greater than it would have been if they have not leveraged the investment.

In the business world, a company can use leverage to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroy shareholder value.