You've probably heard the term "leverage" before—but what is it, and why does it matter?
In a nutshell, leverage allows you to use other people's money to make more for yourself. For example, if you want to buy property but don’t have all of the upfront capital, you’re using financial leverage in the form of mortgage.
There are many other ways investors can utilize financial leverage for gains. This article will give you a deep dive into leverage so that you can better understand how it works and how it can improve your returns.
How Does Leverage Work?
Financial leverage works by using borrowed funds to increase the investor’s purchasing power and potential return on investment. Both investors and corporations can use financial leverage. Investors use it to increase buying power, while corporations use it to fund operations.
Different Types of Leveraged Financial Instruments
There are different types of leveraged securities investors can choose from. You can go for securities, like options or futures, or choose to take out different types of loans.
Margin loans use the total assets in an investor’s account as collateral for borrowing additional funds to invest. A margin loan allows you to borrow money to invest in approved shares or managed funds, using your existing cash, shares, or managed funds as security.
When a trade results in a gain, the investor keeps the profit, and the broker takes the cost of the borrowed money. Margin loans are easy to use, and the capital is flexible, so you can use it in the stock market, crypto, or indices.
Stock and Index Futures
Futures contracts are agreements between two parties to buy or sell an asset at a predetermined price on (or by) a specified date. These arrangements allow both players and speculators to lock in prices that they feel will benefit them while protecting against unpredictable swings in the market. You can buy futures on commodities like coffee, stock indexes like the S&P 500, or cryptocurrencies like Bitcoin.
Stock and ETF Options
Stock and ETF options are both investment contracts that give you the right, but not the obligation, to buy or sell a stock at a specific price on or before a certain date.
Stock options are contracts between two parties: the buyer and the seller. The buyer is called the "holder," and they have the right to purchase shares of stock at or before some date in the future at an agreed-upon price.
ETF options work similarly: two parties enter into an agreement where one party has the right but not the obligation to trade their ETF shares for another party's money on or before some date in the future.
What Asset Classes Can Leverage Support?
Since leverage is just borrowing money and using that to invest, it can support literally any asset class—it’s just a matter of how much debt you’re willing to enter and how much risk you’re ready to take.
Benefits of Leveraged Investing
Financial leverage is a powerful tool for investors. It allows you to achieve more with your money, and it can help you take advantage of opportunities that might otherwise be out of reach by increasing your buying power. Here are some of the most common ways financial leverage benefits investors:
1. Increased Access to Capital
By increasing your buying power, leverage magnifies the potential rewards and mitigates risks inherent in a given investment. For example, if you invest in a leveraged product like futures and your prediction panned out, you stand to make a lot more than if you had purchased the share outright.
2. Greater Potential for Reward
Investors can access higher-value stocks on the stock market, invest in large-cap companies with a small down payment, or increase their ownership of an investment without making a sizeable initial payment.
3. Mitigation of Risk
When you invest using leverage, you get to keep any cash savings or assets you may have, helping you feel more financially secure.
Risks of Leverage
However, using leverage comes with some risks. The major ones to be aware of are:
1. Increased Potential for Losses
If an investment made with borrowed money loses value, the investor is responsible for recuperating the lender’s losses. People also tend to take on larger investments which exposes them to more risk.
2. High Interest Rates and Premiums
Banks and brokers tend to charge extra fees and premiums on top of the interest, which can potentially cut into profits.
3. Exposure to Volatility
Leverage also exposes investors to more volatile assets, like companies using debt financing to fund operations. Greater volatility can mean more money, but it also means more risk.
Leverage, while great, can have some serious consequences if not used properly. Leverage is actually thought to be one of the primary drivers of the 2008 housing crash.
Private households, corporations, and banks all became overly leveraged, fueling a housing bubble. When the bubble burst, banks were left with trillions of dollars in worthless subprime mortgage investments. The economic crisis that followed cost many people their jobs, savings, and homes.
How Institutional Investors Invest with Financial Leverage
While most of our previous discussion on financial leverage in investing has been focused on retail investors, institutional investors like hedge funds and corporations commonly use financial leverage to increase their profits. Let’s dive into some of the strategies used by leverage pros:
How Hedge Funds Use Financial Leverage
When a hedge fund invests in securities, they don’t use their own money. They use borrowed money or financial leverage.
They do this to target a level of return volatility desired by investors without risking their equity. They employ a few different strategies to work with leverage, which we’ll dive into here.
A common method hedge funds use to generate large returns is purchasing securities on margin. This is a strategy that allows investors to use borrowed funds to invest.
The investor borrows from a broker at an interest rate for this service, but the payoff can be huge. In fact, many hedge fund managers have made their fortunes by using this method to generate outsized returns on their investments.
Imagine an investor who buys stock for $1,000, with half of it (or $500) coming from their own cash and the other half on margin. If this stock then rises to $2,000, the investor quadrupled their initial investment. If they had purchased the stock with 100% of their money, they would have only doubled their returns.
Using Credit Lines
Investing using credit lines is similar to trading on the margins, but instead of borrowing money from a broker, the hedge fund uses borrowed funds from a third party.
Another way hedge funds use financial leverage is through derivatives. A derivative is a financial contract that's derived from the price of an underlying security. The most common derivatives are futures and options.
Hedge funds use derivatives because they offer asymmetric risk exposure. This means that if you make a trade involving a derivative, you will either have a greater potential loss or greater potential gain than the original amount of money that you risked.
For example, risking $500 for the potential to win $2,000 is an asymmetrical trade. On the other hand, if you risk the same $500 but only have the potential to make $500, you’ve made a symmetrical trade.
How Corporations Use Financial Leverage
Financial leverage works a bit differently for corporations. Leverage can be a key component of your business's growth strategy.
Companies use debt to invest in business operations like new projects, finance the purchase of inventory, and expand their operations—all without issuing stock. Debt is also tax deductible in many cases.
For many businesses, debt can be a less expensive source of growth capital than equity or asset sales. For example, a company’s stock price would fall if they were to sell to fund operations. Instead, they’ll take on debt, which is known as their operating leverage.
High operating leverage means that a company stands to significantly improve its net income by taking on debt. A lower ratio indicates the opposite. More debt allows also allows companies to have a lower equity base resulting in a higher after-tax profit or an increase in the company’s equity.
However, companies can sometimes get carried away and end up taking on too much debt. Luckily, there are several methods to measure financial leverage, which we’ll dive into here.
New investors may be hesitant to borrow money for their investments. You should now know what leverage is and why it can be so beneficial for your portfolio. You should also have a better understanding of how you can use leverage in your investment strategy.
Whether you're using leverage to purchase securities or you want to invest in leveraged products (or both), there is a lot of potential for amazing returns. With Hedgeful, you can access leverage and its benefits without full knowledge about it. Join our waitlist to learn more!