Define leverage – Leveraging your trading and investments

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Define leverage – Leveraging your trading

Risks and Benefits Of Leverage

by Gino D’Alessio

Leverage is something we hear a lot about but very few traders take the time to fully understand its usefulness, or risk. It is an immensely powerful trading tool, which magnifies both risk and reward. The definition for trading leverage is;

The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

Crucially, it can mean investors can lose more than their initial deposit.

Here, we explain that definition more fully;

What exactly is Leverage?

Leverage is the concept of borrowing money to add to your own capital to make a bigger investment. It started with the stock markets and was called margin investing. What happens in the stock market is you place for example, £10,000 with your stock broker and they lend you (or give you the ability to invest) another £10,000. This allows you to invest a total of £20,000, for your initial deposit of £10,000 – which sounds very attractive. So if you have picked the right stocks and the value of your portfolio goes up 10%, you are in a position to make £2,000. That is 10% of your total investment amount of £20,000. Effectively this borrowed money allowed you to make 20% on your initial capital of £10,000. This loan from your broker does come with a small cost, as they are often going to charge you more commission as you are investing with more money. There may also be interest charged on the loaned amount, or charges for keeping positions overnight. At present, with very low interest rates, those fees are minimal, but they are worth being aware of

Increased risk of leveraging trades;

We just saw the effects of an investment using leverage that went well, but let’s look at the possibility of a bad trade. In the above example if the stocks you picked went down 10% you would now lose £2,000 which this time is a loss of 20% on your initial capital. So the risk is amplified, just as the rewards are.

It’s easy to see how using leverage has great benefits when you get it right but it may also punish you just as much if you get it wrong. Our example followed a simple 2:1 level of leverage. Effectively doubling the initial investment. But leverage can be considerably higher than that, possibly as high as 100:1 or greater.

Leveraging Forex trading

In the FX markets leverage works the same way. Here is an example; You place your money with a broker and open an account with £5,000. The broker allows you to trade multiples of that figure. If he allows you to trade £25,000 then the leverage you are using is 5 times your initial capital and is called 5 to 1 leverage. You will often see it written as 5:1 which means that for every £1 you place in your account you will be able to trade on £5. Most FX traders will look to make day trades or trades that last a short period of time and take a small percentage profit in terms of price movement. This is feasible precisely because of the leverage being used. You may only need to be in an FX trade for 20 or 30 pips (price points) before you take your profit. 30 pips in GBP/USD (known as Cable) is less than 0.20% in terms of overall price movement. That is an incredibly small move – but if you are using 10:1 leverage you now have a percentage move of 2% compared to your initial capital.

The return including leverage is known as the Return on Assets (ROA). Assets in this case, equal the actual size you trade in. For the example above it was £25,000 and the return was 0.20%. The return on your initial capital is known as the Return on Equity (ROE), and the equity in the above example was £5,000.

So to find out the return on the initial capital we can use these simple formulas;

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How much leverage?

Most FX brokers offer significant levels of leverage. It is quite common to see leverage of 200 to 1 but some brokers advertise leverage of 1000:1

How much leverage you want to use really depends on your trading style. Style in this sense has a lot to do with how long you keep your positions open. The longer you keep your position open the higher the level of risk you are taking. This is simply because there are more chances of the FX pair moving further away from its current price. If you hold a position for a few minutes you will usually not see the price move very far from the open price of the position. Of course that is not the case if you open a position just before data releases.

You need to consider how long your average trade is going to be live. Is your trading strategy going to keep you in a trade overnight? Or even over multiple days? If so, then you may need to consider lower levels of leverage. Cable can move 2% fairly easily within a few days. If your trading strategy is going to have you with open positions over that time frame a 10:1 leverage could see you lose 20% of your initial capital.
If you’re trading style indicates that your positions remain open a matter of minutes then you are generally going to see the market move within a 30 pip range. In the case of cable that represents approximately a 0.20% move but multiplied by a leverage of 10:1 would mean a 2% move. In this case 10:1 doesn’t seem to be too excessive. There will of course be larger moves – even in just a few minutes – so traders must judge their own risk appetite. Obviously using 200:1 leverage can have disastrous effects. A move of 30 pips could change your account balance by 40%, it would feel extremely gratifying if you’re in profit, but a 40% loss could be catastrophic.

How leverage can accelerate growth.

A profitable trade of 2% is an excellent achievement. The compound effect can accelerate growth even further. Assume you can place 1 trade a day and make a profit of 2% from 30 pips. Thanks to leverage, in 20 trading days you could have added 40% to your account. In terms of annual growth, it represents a 480% return. If such growth allowed you to increase the initial equity, trading volume could be accelerated even more quickly. The same level of leverage however, could erode equity just as quickly.

How to Use your leverage

Leverage has to be considered as part of your risk management rules. You also need to consider how you split your use of leverage up. In our example above, we demonstrated using £25,000 leverage on £5,000 of initial equity. That leverage however, can be split over multiple trades. So five trades could be placed with a value of £5,000 each for example. These could be used across multiple assets or currency pairs – or alternatively, used on the same asset, but at different entry points. Placing just one trade and maxing out any leverage is the same as putting all your eggs in one basket.

So leverage is a means by which investors can maximise the returns on their capital. But the increase in potential reward comes with an increase in risk too, and it is important for traders to know exactly how much financial exposure they have at any one time – including the leverage.

Leverage

What Is Leverage?

Leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as “highly leveraged,” it means that item has more debt than equity.

Leverage amplifies possible returns, just like a lever can be used to amplify one’s strength when moving a heavy weight.

Leverage

How Leverage Works

Leverage is the use of debt (borrowed capital) in order to undertake an 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.

The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts. Companies can use leverage to finance their assets. 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.

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.

Key Takeaways

  • Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.
  • Investors use leverage to multiply their buying power in the market.
  • Companies use leverage to finance their assets: instead of issuing stock to raise capital, companies can use debt to invest in business operations in an attempt to increase shareholder value.

The Difference Between Leverage and Margin

Although interconnected—since both involve borrowing—leverage and margin are not the same. Leverage refers to taking on debt, while margin is debt or borrowed money a firm uses to invest in other financial instruments. A margin account allows you to borrow money from a broker for a fixed interest rate to purchase securities, options or futures contracts in the anticipation of receiving substantially high returns.

You can use margin to create leverage.

Example of Leverage

A company formed with an investment of $5 million from investors, the equity in the company is $5 million; this is the money the company can use to operate. If the company uses debt financing by borrowing $20 million, it now has $25 million to invest in business operations and more opportunity to increase value for shareholders. An automaker, for example, could borrow money to build a new factory. The new factory would enable the automaker to increase the number of cars it produces and increase profits.

Special Considerations

Leverage Formulas

Through balance sheet analysis, investors can study the debt and equity on the books of various firms and can invest in companies that put leverage to work on behalf of their businesses. Statistics such as return on equity, debt to equity and return on capital employed help investors determine how companies deploy capital and how much of that capital companies have borrowed. To properly evaluate these statistics, it is important to keep in mind that leverage comes in several varieties, including operating, financial, and combined leverage.

Fundamental analysis uses the degree of operating leverage. One can calculate the degree of operating leverage by dividing the percentage change of a company’s earnings per share by its percentage change in its earnings before interest and taxes over a period. Similarly, one could calculate the degree of operating leverage by dividing a company’s EBIT by its EBIT less its interest expense. A higher degree of operating leverage shows a higher level of volatility in a company’s EPS.

DuPont analysis uses the “equity multiplier” to measure financial leverage. One can calculate the equity multiplier by dividing a firm’s total assets by its total equity. Once figured, one multiplies the financial leverage with the total asset turnover and the profit margin to produce the return on equity. For example, if a publicly traded company has total assets valued at $500 million and shareholder equity valued at $250 million, then the equity multiplier is 2.0 ($500 million / $250 million). This shows the company has financed half its total assets by equity. Hence, larger equity multipliers suggest more financial leverage.

If reading spreadsheets and conducting fundamental analysis is not your cup of tea, you can purchase mutual funds or exchange-traded funds that use leverage. By using these vehicles, you can delegate the research and investment decisions to experts.

The Disadvantages of Leverage

Leverage is a multi-faceted, complex tool. The theory sounds great, and in reality, the use of leverage can be profitable, but the reverse is also true. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would’ve been if he or she had 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.

How Leverage Works in the Forex Market

The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures and margin accounts. Companies can use leverage to finance their assets. 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.

Using Leverage in Forex

In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is activated through a loan that is provided to an investor by the broker that is handling the investor’s or trader’s forex account.

When a trader decides to trade in the forex market, he or she must first open a margin account with a forex broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position that the investor is trading. What does this mean? A 50:1 leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. A 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of trade available as cash in the trading account, and so on. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.

To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into her or his margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading (trading within one day). If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.

How Leverage Can Backfire

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid a catastrophe, forex traders usually implement a strict trading style that includes the use of stop orders and limit orders designed to control potential losses.

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