Leverage describes the practice of using borrowed capital for investment purposes.
Leverage describes the practice of using borrowed capital for investment purposes.
The concept of leverage is widely used in finance, from describing company balance sheets to investing and trading stocks, derivatives, and cryptocurrencies. If an individual or entity is said to be highly leveraged, then their debt is large in relation to their assets or equity.
Companies use leverage when they finance operations, projects, or asset purchases by issuing debt rather than selling equity or using cash on hand. By taking about loans for large purchases, such as a mortgage to buy property, individuals also take advantage of leverage.
Whether in business, investing, or personal finance, the purpose of using leverage is to increase the opportunity for returns. However, using leverage increases risk because it requires traders to use borrowed funds which must always be paid back – regardless of whether the investment is successful. This means that borrowers using leverage can lose more than their initial investment.
Types of leverage
Although leverage is a broad term, it is most often used in business to determine a company’s financial position and in trading to amplify the opportunity for returns.
Corporate financial leverage
The extent to which a company relies on leverage is an essential factor in its valuation; therefore, analysts use various methods to calculate a firm’s leverage ratio.
One example is the Debt-to-Assets Ratio, which divides the company’s total debt by its total assets. If the ratio is close to 1, it means that more of the company’s assets are funded by debts. Typically, Debt-to-Asset Ratios below 1 are considered to be relatively safe, whereas ratios above 1 would stingy that the company is insolvent.
Debt-to-Equity is another example of financial leverage, comparing a company’s debt to its total assets.
Margin trading
Margin trading is another name for leveraged trading in assets such as stocks or crypto. Margin trading requires that the trader posts a certain amount (margin) as collateral, allowing them to borrow more funds with the aim of making larger profits.
Leverage ratios are also used in margin trading to calculate the extent of leverage available to traders. A 10:1 leverage ratio, often also expressed as 10x, allows a trader to place a trade worth ten times the amount of their collateral, so a deposit of $50 would enable a trade worth $500.
If traders face losses that will affect the value of their margin so it falls below a particular threshold, known as the maintenance margin, the trader will often be notified to top up their account. If they fail to do so, they may face liquidation or other penalties from their brokerage or exchange, potentially including being barred from trading on margin.
Example crypto leverage trading
A trader has a margin of $1,000, and the exchange offers a leverage ratio of 10:1, or 10x, meaning their trading amount equals $10,000. Bitcoin is currently trading at $50,000, but the trader believes its price will go down. Using the available leverage, the trader sells 0.2 BTC at a price of $10,000. The trader then waits for BTC to reach $45,000 so they can buy 0.2 BTC at the lower price of $9,000, which would generate a $1,000 profit. A 10% favorable price move times 10x leverage equals a 100% profit on the trade.
However, if they bet wrong and the price goes to $55,000, they would incur a $1,000 loss which would wipe out the entire balance of their collateral, despite the price of the asset only moving 10% against them.
Now let’s repeat the same example with 20x leverage. The trader would be able to sell twice as much – 0.4 BTC at $20,000, based on a $50,000 market price. If the price goes to $45,000, the trader could buy back 0.4 BTC at a price of $18,000, making a $2,000 profit.
But the losses would also amount to $2,000 if the BTC price goes to $55,000 since it would cost $22,000 to repurchase 0.4 BTC. In this case, the user has not only lost all of their initial collateral, but they’ve now incurred a further $1000 of debt they owe to their lender. Typically brokers and exchanges have risk procedures in place to liquidate positions before this scenario occurs.
Caution with leverage trading
Traders use leverage to enhance the opportunities for gains and make more effective use of available capital. However, the high risks involved in leveraged trading stingy that strictly regulated in many jurisdictions, including in the United States.
Leverage traders often deploy a range of tools, such as stop-loss and take-profit orders, which help to mitigate the risk of losses and reduce the need to continually monitor open positions. Markets that are more volatile, like the cryptocurrency markets, make leverage trading even more risky. Before utilizing leverage, traders should carefully evaluate their own willingness and ability to take its associated risks.
Leverage essentials
- Leverage is where individuals or companies borrow funds to invest – higher leverage means more debts.
- Margin trading is the practice where traders borrow funds against collateral so they can make bigger trades.
- Trading with leverage amplifies the opportunity for profit but also for losses, so it is considered a high-risk practice.