What is leverage?

Podcast Duration: 05:08
Hi Friends, and greetings from Angel One

Today we are going to talk about a very common and powerful concept in the world of trading. Can you make a guess?

We are talking about leverage today!

So friends, leverage is basically the use of borrowed capital, or debt towards an investment. The objective of using leverage is to amplify the returns on an investment.

So why doesn’t everyone use leverage? After all, the returns on your investment can be amplified using leverage. That’s because leverage also multiplies the risk associated with your investment.

Got it?

Friends, leverage is used by individuals and companies alike. But before we talk about how it is done, let’s talk about the word origin - have you seen a bottle opener? Without it, cracking your soda bottle open takes so much effort. But the opener amplifies the effort you put, and opens the bottle easily.

This is exactly how leverage gives an amplifying boost to your investment.

So how is this concept used in trading? Let’s talk about individual investors first.

Investors basically lever their investments with instruments like futures, options, and margin accounts.

Companies, on the other hand, finance their assets for leverage. So instead of issuing stocks to raise funds, companies use debt financing to invest in business operations. The objective here is to generate value for the shareholder.

Now, for individuals, there is another option to access leverage, if making use of leverage directly is not something they are comfortable with. So how is that done?

To do that, investors can choose to invest in those companies which make use of leverage in their operations or expansion efforts. Sounds simple, right? Then let’s move ahead.

Friends, are you familiar with the concept of margin accounts? If not, then let’s review it once - because both leverage and margin accounts are similar concepts that involve borrowing. But they should not be confused. Basically, you can make use of margin accounts to borrow money from your broker.

This money is borrowed on a fixed interest rate basis, which is then used to purchase securities, options, futures contracts, etc. The idea is more or less similar to leverage.

That’s because leverage is a wider umbrella term - margin accounts are essentially one of the many ways to create leverage.

To create leverage, investors also make use of personal loans. Apart from that, investors can also finance their properties to create leverage. However, this is not advisable.

Even personal loans can put you in a tricky spot. Basically, if the interest rates on your personal loans change, then it can drag down your returns, and further maximise your losses in case your investment goes south. So let’s see how leverage works.

Imagine that you are investing 1000 rupees in some stocks. You are optimistic about it’s growth, and your detailed analysis predicts a solid 20% growth on these stocks. In such a case, you will end up with Rs 1200 at the end of the year.

Now imagine that you borrowed Rs 19000 for the same investment at an interest rate of 5%. In this case, you will end up with Rs 24,000 at the end of the first year. At the given interest rates, you will return around 20000 rupees to the bank, leaving you with a profit of 3000 rupees.

Where the return on your investment without leverage was 20%, the return with leverage got multiplied by a factor of 15! But keep in mind that leverage also involves huge risk. In case the investment doesn’t give adequate returns, or even faces losses, you still have to pay back the debt, with interest. So taking leverage has to be a very carefully thought out decision, as it increases your liabilities.

So friends, the concept of leverage is used by companies almost everywhere - in hedge funds, expansions, and even leveraged buyouts.

Now you must also have an idea about how leverage multiplies risk and losses too. In our last example, if our prediction was wrong and the stock declined at 10% over the year, then making use of leverage would land you in a debt of 1000 rupees after losing all your capital.

Friends, this example had exaggerated and rounded numbers to help you understand the concept easily. In the real world, while the rates will be different, the concept remains the same.

Generally, beginners in the stock market are advised to stay away from using leverage. The above example is precisely why - leverage can be a high-risk game. It can multiply the risk in your portfolio.

That’s why, before leveraging your investment, you must have a strong confidence in the growth of those particular stocks. This should be backed by an in-depth technical and market analysis.

It is said that leverage is for investors with a strong market experience and a high risk appetite. And if you do not have financial capability to support debt, then you should ideally stay away from leveraging.

So friends, that’s all we have for today’s podcast.

If you like what we talked about, don’t forget to share this podcast.

Goodbye friends - Angel One wishes you a good day ahead.