What Is Financial Leverage?
Financial leverage is simply using debt to finance a trade. As simple as that. That is, instead of executing a trade with your own funds, you trade with a combination of your own money and credit provided to you by your broker. The main advantage is that you can multiply profitability, but you can also multiply your losses as well.
Let’s take a numerical example that will hopefully make things a bit clearer. Let’s imagine that we want to spend $1 million in shares. After one year the shares are worth 1.5 million euros and we sell them. We have achieved a profitability of 50%.
What happens if we execute the same trade with some financial leverage? Imagine that we put $200,000 and a bank lends us $800,000 at an annual interest rate of 10%. After one year, the shares are worth $1.5 million and we sell. How much have we earned? First, we must pay $80,000 in interest back. And then we must return the $800,000 loaned to us. That is, we won 1.5 million – $880,000 – $200,000 euros = 420,000. Less than before, right? Yes, but in reality our starting capital was $200,000, and we have earned $420,000, or 210% ROI.
However, there are also risks. Imagine that at the end of the year the shares are not worth $1.5 million, but $900,000. In the event that there is no leverage, we have lost $100,000. In the case with leverage we have lost 100,000 euros plus $80,000 in interest. Almost double. But with a very important difference. In the first scenario, we lost money that was ours, we had 1 million that we invested and we lost 10%. In the second scenario, we had $200,000 and have to pay back $880,000 of the $900,000 worth of shares. We only recovered $20,000. That is, the losses are 90%. Losses also multiply with leverage!
And most seriously, imagine that the shares are worth 800,000. Not only would we have lost everything, but we could not afford to pay 80,000 to the bank. We are insolvent.
Leverage is often defined as the ratio of equity to credit. For example, before we were at a 1:4 ratio. For each dollar of equity, the bank put in 4. That is quite reasonable. When leverage levels are higher, the risks are also greater, and in recent years we have (I hope) learned to be careful when trading on leverage.