Leverage is an important concept in the financial market. It refers to the process of using borrowed money to amplify your trading success.
When used well, leverage can help you boost your profits in all types of assets, including stocks, currencies, and commodities. This article will explain how leverage works and assess its risks and benefits.
Leverage definition
Leverage is defined as the process of using borrowed money in trading and investing. The idea is that using such funds will help you become more profitable if things go your way.
In most cases, brokers and exchanges provide the leverage themselves. And in some instances, a trader can add to their leverage by borrowing funds from other sources.
Leverage vs margin
The concept of leverage goes hand in hand with that of margin. As mentioned above, leverage is a loan that amplifies a trader’s trading amount.
Margin, on the other hand, is the amount of money that a trader needs in his account to maintain their leverage. On the one hand, margin is the amount of money you need to open a position while leverage is the multiple that you can borrow.
A margin call is one of the most feared things in finance. It refers to a situation where the lender asks you to add money to maintain your trade. If you fail to add these funds, your loss-making trade will be ended and you will take a big loss.
Related » How Margin Trading Works
How leverage works
A common question is how leverage works. Let us look at a good example to answer this question.
Assume that you have $10,000 to invest and you find a stock that is trading at $10. In this case, without leverage, you can buy 1,000 shares. If the stock rises to $15, your total profit, excluding trading costs, will be $5,000. [(15×1000) – (1,000 x 10).
Assume that you are really confident that the stock will go up to $15. As such, you decide to borrow another $10,000 to invest in it. In this case, you will have $20,000, which you can use to buy 2,000 shares.
As such, if the stock rises to $15, your total capital will be $30,000. So, you return $10,000 to the lender and your profit becomes $20,000.
Therefore, as you can see, leverage can help you make more profits when day trading and investing in the financial market.
Brokers provide leverage in terms of a ratio such as 1:100, 1:200, and 1:50. These ratios show the amount of money that you can borrow to trade. For example, if you use a 1:100 and you have $2000, it means that you can trade as if you have $200,000.
Let us look at two more types of leverage: leveraged buyout and leveraged tokens.
What is a leveraged buyout?
Another important concept used in high finance is known as a leveraged buyout. This is a situation in which a company or an individual uses a substantial amount of debt to fund an acquisition. In most cases, this debt is usually backed by a company’s assets.
A good example of this is when Elon Musk acquired Twitter in a $44 billion. To fund the acquisition, Musk spent some of his own cash and partnered with some of his friends. The other portion of the deal was through loans, which were backed by Twitter itself.
Therefore, after buying Twitter, Musk started using the company’s revenues to pay back these debts.
Other popular leveraged buyouts were companies like PetSmart, RJR Nabisco, and Hilton Hotels among others.
Related » How to Trade Corporate Merger and Acquisitions
What are leveraged tokens?
Another concept you need to know is leveraged tokens. Leveraged tokens are relatively new financial assets in the cryptocurrency industry. They are crypto tokens that seek to amplify the trading profits for a trader.
For example, a token like ETH BULL 3X, means that a trader will make three times their money when Ethereum goes up by 1%. These leveraged tokens are offered mostly by leading crypto exchanges like FTX and Binance.
How to use leverage well
So, how do you use leverage well to maximize your profits? First, you need to start your trading career with a small leverage ratio. You can even start with a leverage ratio of 1:2.
While the profits, in this case, will be limited, it will help you master your trading process. You can then add to your leverage as you become more experienced.
Second, come up with a good battle-tested trading strategy. Ultimately, this strategy is what will make you reduce the likelihood of making a big loss in trading.
Third, always have stops in your trades. A stop-loss is a tool that automatically stops your trade when it reaches a certain loss level. The benefit of having a stop-loss is that it will limit the maximum loss that you can make. In most cases, it will prevent you from making a negative loss.
Benefits of leverage in trading and investments
Leverage is an essential concept in trading and investment. Its biggest benefit is that it makes it possible for a trader to buy more assets than what they have in their accounts. As demonstrated in the example above, leverage can lead to substantial profits.
Meanwhile, in broader finance, leverage can make it easy for you to buy an asset that you believe is undervalued and then boost its value.
For example, Blackstone made billions of dollars when it exited its highly leveraged investment in Hilton.
Cons of leverage
Leverage has many disadvantages, which explains why it is a highly regulated aspect. In 2018, the EU passed MiFID II regulations that put the maximum leverage that a broker can offer to 1:30. The same regulations on leverage were adopted by Australia.
There are several cons of using leverage. First, you can lose more money than what you invested. In the example above, assume that the stock actually dropped to $5.
Without leverage, you would have lost $5,000. With leverage, your loss would have been significantly higher than that. This happens since leverage involves borrowed money, which you will need to pay back.
Second, leveraged buyouts limit how companies can grow since it introduces substantial debts to the firm. This explains why many leveraged buyouts end in bankruptcy.
Summary
In this article, we have looked at what leverage is and how it works. We also assessed other popular concepts in leverage like leveraged buyouts and leveraged tokens.
Most importantly, we have explained some of the top pros and cons of using leverage when trading. Because it is not a tool to be used carelessly.
External Useful Resources
- Different Types of Leverage – Analytics Steps
