Investing can feel like riding a rollercoaster.
You go up, down, and sometimes sideways, all in the quest for that perfect return.
Some investors, in the hope of getting to the top of that rollercoaster faster, use leverage as a tool to boost their profits.
Sounds exciting, right? But hold on—leverage comes with its own set of risks.
If you don’t handle it carefully, it can turn into a free fall. So, what exactly is leverage, and why is it so risky? Let’s break it down.
What Is Leverage?
Leverage is a bit like borrowing a car to go on a road trip. You get the car and hit the road, hoping for an exciting adventure. In investing, leverage means borrowing money to increase your investment’s potential return. You’re using other people’s money (typically from a broker) to magnify your position in the market. The idea is that if things go well, you can make a lot more profit than you could with your own money alone.
But remember—just like that borrowed car can break down, investments using leverage can take a wrong turn too.
How Does Leverage Work in Investing?
Here’s a quick analogy. Imagine you have $1,000 to invest in stocks. Without leverage, you simply buy $1,000 worth of stock. But with leverage, you can borrow an additional $1,000 from a broker and buy $2,000 worth of stock. If the stock price goes up, your profits are higher because you control more shares.
Let’s break this down with numbers:
- If your stock goes up by 10%, your $2,000 investment grows to $2,200.
- You borrowed $1,000, so after paying back the loan, you’re left with $1,200. That’s a $200 gain on your original $1,000, or a 20% return.
Leverage just doubled your profits! But what happens when the stock price goes down?
The Dark Side of Leverage: Losses Are Magnified Too
Here’s where things get risky. Just as leverage can magnify your gains, it can also magnify your losses. Let’s say your stock drops by 10% instead of going up. Now, your $2,000 investment is worth $1,800.
- After paying back your broker the $1,000 you borrowed, you’re left with $800.
- That’s a $200 loss on your original $1,000, or a 20% loss. Ouch.
Without leverage, your loss would’ve only been 10%. But with leverage, it’s doubled to 20%. And it gets worse if the stock drops further. The more leverage you use, the more extreme your losses can be.
Why Do Investors Use Leverage if It’s So Risky?
Why, you ask? It’s simple—greed and ambition. Everyone wants bigger returns, faster. Leverage can make you feel like a financial wizard when things go well. But it’s important to remember that leverage isn’t magic; it’s just borrowed money.
Many investors use leverage to make up for a lack of capital. Imagine you see a stock with great potential but don’t have enough cash to buy a significant amount. Leverage gives you the ability to make larger trades than you could on your own.
But here’s the kicker: leverage doesn’t just amplify your financial position—it amplifies your emotional one too. When you’re leveraged, every price change feels more dramatic. You might become more anxious, second-guessing every market move.
Margin Calls: The Nightmare of Leveraged Investors
If you’re using leverage, there’s one word that can send shivers down your spine: margin call. So, what exactly is a margin call?
When you borrow money to invest (also known as trading on margin), your broker requires you to maintain a certain amount of equity in your account. If your investments lose value and your account balance drops below this required level, you’ll receive a margin call. This means you need to either deposit more money or sell some of your investments to meet the requirement.
A margin call can force you to sell at the worst possible time, locking in your losses. It’s like being forced off the rollercoaster ride halfway through, right when it’s plummeting down.
Understanding Leverage Ratios: More Power, More Risk
Leverage is often expressed as a ratio. A leverage ratio of 2:1 means you’re borrowing the same amount of money as you’ve invested. For example, if you invest $1,000 and borrow another $1,000, your leverage ratio is 2:1.
Higher leverage ratios mean more borrowing—and more risk. Some professional traders use leverage ratios as high as 10:1 or 20:1. But be warned: with great power comes great risk. A small drop in the value of your investment can wipe out your entire position when you’re using high leverage.
So, before you jump into the world of leverage, ask yourself: how much risk can you stomach?
Common Leverage Instruments: ETFs, Futures, and Options
Leverage isn’t just for stocks. There are several investment vehicles that allow you to use leverage, each with its own level of risk.
Leveraged ETFs
Exchange-Traded Funds (ETFs) can be leveraged to increase your exposure to a particular market or sector. These funds aim to deliver multiples of the performance of an index, like the S&P 500. For example, a 2x leveraged ETF seeks to deliver twice the daily return of the index.
Sounds great, right? But the problem with leveraged ETFs is that they’re designed for short-term trading. Over time, the performance of these funds can deviate significantly from the index they track, leading to unexpected losses.