Sunday, February 21, 2010

What is Leverage?

In personal finance, the concept of leverage involves an investor using his or her own money to purchase an asset, such as a stock, and then borrowing money from a broker to purchase more of that stock. The investor "leverages" his or her own funds to increase return. With a 50 percent margin requirement, the investor puts up 50 percent of the money to purchase the stock. The investor has leveraged his own money by a factor of 2.

This allows an increase in return. Ignoring interest on the loan, if the stock increases in value by 10 percent, the investor receives a 20 percent return on his investment.

Suppose an investor has $10,000 available for investment. The investor borrows an equal amount, $10,000. The $20,000 is invested in the stock. The stock rises in value by 10 percent, so it is now worth $22,000. The stock is sold and the investor earned a $2,000 capital gain. After paying back the $10,000 loan, the investor now has the $12,000. A $2,000 gain on a $10,000 investment is a 20% return.

But leverage is "risky." Suppose the stock falls in value by 10 percent. The investor again puts up $10,000 and borrows another $10,000 and buys $20,000 worth of stock. The stock falls in value by 10 percent. It is now worth $18,000. The investor sells the stock and then pays back the $10,000 loan. The investor has $8,000, which is $2,000 less than the original investment. The loss is 20 percent.

Suppose the stock fell in value by 50%. Again, the investor had $10,000 to invest and borrowed another $10,000 to purchase $20,000 worth of stock. The stock falls in value by 50 percent and it is now worth $10,000. This is sold, and all $10,000 is used to repay the loan. The investor has nothing left. The stock fell in value by 50 percent, and the investor has lost 100 percent of his investment. All the hard earned savings are gone.

It could be worse. Suppose the stock falls in value by 60 percent. The investor put his $10,000 up and borrowed $10,000. The stock fell in value to $8,000. The investor sells the stock and has $8,000. But he or she owes the brokerage firm $10,000. The investor has turned the $10,000 that he had saved into a $2,000 debt.

While "leveraging" an investment provides better a better "upside," the downside risk makes it look like a foolish strategy. At least, I would never leverage my limited savings.

But supposedly the "banks" on Wall Street were leveraged 35 to 1. The examples above were based upon a 2 to 1 leverage ratio. Think about the upside? At 35 to 1, a 10% increase in stock prices results in a 350% gain. On other other hand, a 3% decrease in stock prices would result in a 105 percent loss, and so a $5 billion dollar investment would turn into a $250 million debt. No wonder we had a financial crisis!

However, the personal finance version of "leverage" has little connection to the corporate finance version of "leverage" and less connection to the banking version of "leverage."

And there is next to now connection with a household that lived it up on borrowed funds, and spent more on consumer goods and service than its income, and now has to pay down those debts by consuming less than income.


  1. Thanks for explaining leverage. A 35 to 1 leverage ratio sounds insane. I wonder what kind of pressure a banker is under to have this kind of leverage if everyone else is doing it. If your competitors are making phenomenal returns are you supposed to sit back and be conservative in your investments or are you under enormous pressure to throw the dice?

    Given these high leverage ratios did the bankers on Wall Street know that if their investments failed the government would bail them out? Or were bankers just completely insane take such high risks? Now we know that the banks were bailed out, but did the bankers know in advance that they would be bailed out if everything crashed?

  2. Leverage for me means big thing, as it is the stuff that can make all the difference in the world. As I trader, I generally seek for big leverage given that I have low investment in place. I am extremely fortunate that with OctaFX broker, I get great advantage due to their huge leverage up to 1.500, it really boost my low investment and keeps the risk factor down, so that increase the profit chance automatically and makes me feel very secure.