Financial leverage is a powerful tool that has the potential to magnify returns and enhance profitability, but it can also amplify risks and lead to catastrophic losses.
Whether you are trading stocks, taking out a leveraged loan, or investing in Forex, understanding the concept of leverage is essential to making informed financial decisions.
This article will explore what leverage means, how it works, and the risks and benefits associated with using it in various financial contexts. We will delve into the formula for leverage, the advantages and disadvantages of leveraged loans, and the potential rewards and pitfalls of investing with leverage.
What Does Leverage Mean?
In the world of finance, leverage is a popular investment strategy that involves using borrowed money to increase the potential returns on investment.
Essentially, leverage in financial markets means using debt, or borrowed capital, to undertake a project or investment. The upside is that it can multiply potential returns, providing an opportunity for significant gains.
However, it's important to note that leverage multiplies the potential downside risk if the investment doesn't pan out. That's why it's crucial to approach leverage cautiously and carefully weigh the risks and rewards before deciding to use it.
Investors use leverage to boost their returns by using various financial instruments, such as options, futures, and margin accounts. These tools can help investors leverage their investments and potentially increase returns.
Understanding What is Leverage in Trade
To understand what leverage is in trade, let us take a look at an example. In the case below, we mainly look at leverage on stocks, which will elaborate on how leverage is calculated.
Let's say that the trader wants to invest in Intel stock, currently trading at $28.50 per share. They believe that the stock is undervalued due to a potential announcement of an investment by the US government to fund semiconductor companies to manufacture in the US, thereby leading to a jump in the stock.
The trader decides to use leverage to maximize returns. In this scenario, they use 8x leverage to borrow $14,000 from their broker, giving them a total investment of $16,000. With the new capital, the trader is able to purchase 561 shares of Intel stock at the current price of $28.50 per share.
When news shows that Intel has received a significant $30 billion investment from the US government, the stock shoots up to $33/share. This results in the trader's investment worth $18,513, representing a profit of $2,513, a 2.25x return on the original investment, as opposed to a measly return of 15.7% had the trader not used any leverage.
Advantages and Disadvantages of Leverage
Before you rush out to invest with leverage, you should weigh the advantages and disadvantages of using financial leverage.
Advantages of Leverage
Amplified profits: Leverage can help investors increase their profits by amplifying their winning investments. With additional upfront capital, returns on winning trades can be exponential.
Access to more expensive investments: Leverage also allows investors to access more expensive investment options that would otherwise be out of reach with smaller upfront capital.
Disadvantages of Leverage
Higher downside risk: While leverage can increase profits, it also comes with higher downside risk. Losing investments can be amplified, sometimes resulting in losses greater than the initial capital investment.
Additional fees: Brokers and contract traders charge fees, premiums, and margin rates, even on losing trades. This means investors will still be on the hook for extra charges, even if they lose on their trades.
Complexity: Leverage can be complex and requires investors to know their financial position and the risks they inherit. This may require additional attention to their portfolio and capital contribution if the trading account does not have sufficient equity per the broker's requirement.
Types of Financial Leverage
Let us understand the different types of leverage loans before investing with leverage,
Margin Account
A margin account is a brokerage account that enables investors to borrow money from a broker to purchase securities. The margin varies depending on the type of asset purchased and based on the broker. Generally, as a rule of thumb, most stocks have leverage caps of up to 7x-10x, while crypto investments have a cap of between 10x-100x.
Derivatives
Derivatives are financial contracts that derive value from an underlying asset, such as stocks, bonds, or commodities. There are several derivatives traders can use to boost returns, including options, futures, and swaps.
Loans
Investors can take loans from banks or other financial institutions to finance their investments. By using borrowed funds, investors can amplify their gains if the investment performs well.
Leverage Loans: A Cautionary Tale
As pointed out earlier, leverage has the potential to transform trades, vastly multiplying the investment returns for a trader. But it also comes with significant risks. Leverage can lead to complete financial ruin and significant financial collapses. Let's look at an instance when Leverage Loans led to a complete financial system disruption.
Archegos Capital
Bill Hwang and Archegos Capital Management began pursuing an aggressive investment strategy in March 2020, whereby he amassed positions in a handful of securities using a derive called total return swaps. Banks offered Archegos returns based on stock performance, allowing Hwang to accumulate leveraged positions without disclosure.
Archegos had over $10 billion in Baidu and Tencent Music and over $20 billion in ViacomCBS, with derivatives comprising over 50% of the latter. Archegos used nine banks to create the illusion of multiple parties, enabling leverage of up to 1,000%. The fund misled banks about its exposure with other dealers, allowing it to borrow and trade more.
However, things started to fall apart in March 2021, when Viacom CBS announced a secondary stock offering of $3 billion, which saw a crash in Archegos' portfolio. Hwang launched a considerable effort to prop up Viacom, using $2 billion in trading that depleted Archegos' cash reserves, but despite this, Viacom's stock continued to decline.
For two days, Hwang and his team tried to delay the banks from calling in their loans, but on March 26, they ran out of time. The banks began to unwind the trades, causing the shares to plummet. Hwang personally lost $8 billion, while Archegos, which once managed $36 billion in assets, went out of business.
What is the Most Appropriate Leverage for Traders?
Every investor has a personal preference for what makes an excellent financial leverage ratio. While some may be risk averse, others may see leverage as an opportunity to access capital and increase profits.
As a general rule of thumb, leverage of 2x is widely accepted and is considered risk averse. However, if interest rates increase, leverage can hurt those investors who borrow.
Conclusion on Financial Leverage
Financial leverage is a double-edged sword that can significantly enhance returns and profitability, amplify risks, and lead to significant losses. Understanding the concept of leverage and its implications is crucial for making informed financial decisions, whether you are trading stocks, investing in Forex, or taking out a leveraged loan.
By considering the risks and benefits of using leverage and carefully evaluating your risk tolerance and financial goals, you can use leverage as a powerful tool to help achieve your financial objectives.
Frequently Asked Questions on Leverage
What is leverage ratios?
Leverage ratios are financial metrics that measure the amount of debt an investor has relative to his assets or equity to assess its total exposure.
For example, a leverage of X2 means that the total exposure of an investor is double its own contribution in equity.
A very illustrative example can be obtained if we set up a leveraged trade on Etoro.
The left picture shows the process of setting up a non-leveraged position, i.e., Leverage is "X1". As expected, the $1,000 invested amount is equal to the total exposure of $1,000. That means we can use our money to purchase 10.23 shares of AMD stock.
Note that this is also a commission-free trade (not counting the spread).
The right picture shows the process of setting up an X5 leveraged trade. As you can see, the total exposure of $5,000 is five times higher than our investing amount of $1,000. This results in the fact that we can now purchase 51.06 shares of the same AMD stock, i.e., five times more.
Note that we do have a fee in this case. We would have to pay that fee regardless of whether we gain or lose money with this trade. An additional note is that in this case, the work is a CFD (Contract For Difference), i.e., we are not buying the underlying asset. The purchase price is also higher, as the platform applies a higher spread for leveraged trades.
So, let's now evaluate potential gain vs. potential loss.
Potential gain
Suppose we would like to close the trade and harvest the profits when our capital increases tenfold. So we will set the "Take Profit" at $10,000.
In the X1 leverage case, we have to wait for the AMD stock to hit $1,075 per share.
In the X5 leverage case, we only have to wait for the AMD stock to hit $293.
The difference is noticeable; we were able to tenfold our money while the stock only tripled in price.
Potential Loss
As you might have already guessed, the potential loss is also amplified.
Assume we would like to close the position and support the loss at -50%.
In case of no leverage, it's simple. If the share price halves, we lose 50% of our investment amount, i.e. at a share price of $48.89.
However, in the case of X5 leverage, the -50% loss would be hit at a much higher stock price. In other words, a significantly smaller drawdown would cause us to lose -50%. To be more exact, in the case of X5 leverage, we would lose half of the invested money if the stock price drops to $88!
Is the reward worth the risk?! I leave that conclusion to you.
Dual and Tripple Leverage ETF
Leveraged ETFs are exchange-traded funds that use financial derivatives and debt to amplify the returns of an underlying index or asset.
Dual and triple-leveraged ETFs are ETFs that use two or three times the exposure of the underlying asset, respectively.
Dual-leveraged ETFs attempt to double the daily return of an underlying index or asset. For example, if the underlying index goes up by 1%, a dual-leveraged ETF would aim to go up by 2% on the same day. Similarly, if the index goes down by 1%, the ETF would attempt to lose 2% on the same day.
Triple-leveraged ETFs, as the name suggests, aim to triple the daily returns of the underlying index or asset. If the underlying asset gains 1%, the triple-leveraged ETF would seek to go up by 3% on the same day. Similarly, if the underlying asset loses 1%, the ETF would aim to lose 3% on the same day.
While leveraged ETFs can offer potentially higher returns than traditional ETFs, they also carry higher risks. Using leverage can amplify losses and gains, so investors need to be aware of the risks before investing in these types of funds.
An example of a dual-leveraged ETF is ProShares Ultra S&P500 (SSO). The fund seeks to track 2x the daily performance of the S&P 500 Index by using the complete replication technique.
An example of a triple-leveraged ETF is ProShares UltraPro QQQ (TQQQ). The fund seeks to track 3x the daily performance of the Nasdaq-100 Index by using the complete replication technique.
As you can see in both cases, the leveraged ETFs are much more volatile but also can bring a significantly higher return.
Quotes on Leverage
“When you combine ignorance and leverage, you get some pretty interesting results." ― Warren Buffett
“If a company gambles on leverage, it'll probably go bankrupt on leverage.” ― Hendrith Vanlon Smith Jr, CEO of Mayflower-Plymouth
“Leverage is a two-edged sword. The edge that can cut you, cuts deeper.”― Naved Abdali
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