Are you interested in investing or trading in the financial markets? Then you may have come across the term “leverage“. But what does it mean, and how does this concept work? In this guide, we provide a clear leverage definition and explain how it’s applied in finance.
What Is Leverage?
In finance, the term “leverage” refers to the use of borrowed funds to potentially increase the return on investment. In other words, it is a strategy that allows investors to amplify their gains by using borrowed money to control a larger position than they would be able to with their own funds.
What You Need To Know About Leverage
Let’s say you have $10,000 to invest in a particular stock. With this amount, you could buy 100 shares of the stock at $100 per share. If the stock goes up in value to $110 per share, your investment would be worth $11,000, resulting in a $1,000 profit.
Now suppose you decide to use leverage to increase your investment. You could borrow an additional $10,000 from a broker or bank and use this to buy an extra 100 shares of the stock, bringing your total investment to $20,000. If the stock ups in value to $110 per share, your investment would be worth $22,000, resulting in a $2,000 profit.
However, not that while leverage can significantly boost potential returns, it may also result in higher losses if the investment does not perform as expected.
Furthermore, leverage can have a compounding effect on losses. This means that if the value of the investment falls below a certain level, the lender may issue a margin call, requiring the investor to deposit additional funds to cover the losses or risk having their position liquidated.
If the investor is unable to meet the margin call, they may be forced to sell at a loss, potentially wiping out their entire investment. Thus, it’s critical to have a clear understanding of the risks and potential rewards of leverage before introducing it into your investment strategy.
