Leverage means borrowing funds to boost returns from an investment. Investors use leverage to multiply their power in the market. Companies, on the other hand, use leverage to increase their shareholder's return.
How can I use leverage when trading stocks?
- You can engage in stock leverage trading (also called margin trading) by borrowing money from your broker to increase your position size. For example, let's say you want to buy 100 shares of Apple that are trading at $116.60 per share. This means that you will need to put in an initial principal capital of $11,660. However, you only have $5,000, so you decide to borrow another $6,660 from your broker to meet the $11,660 initial investment. After one year, Apple's stocks grew by 20% to $139.92 per share. Your total profit will be $2,332, and after returning the $5,000 to your broker, you will have made 79.8% returns on your initial principal sum of $5,000, almost four times more than the returns that Apple's stock price has gained.
- However, the reality is not so simple, and leverage is a double-edged sword: you can gain more, but you can lose more, too. Let's take the same example. If instead of earning 20%, Apple's stocks fell by 40% after one year due to unforeseen market turmoil. You will have lost $4,664, and after returning the $5,000 to your broker, you will have made a 60.08% loss on your initial investment amount of $5,000, more than 1.5 times more than the losses Apple's stocks incurred. You should also bear in mind that for the entire duration of trading stock on margin, you'll pay additional fees (often hidden), interest, and commission.
- Instead of trading using leverage yourself, you might want to invest in hedge funds as they often use high leverage strategies. Hedge funds are known for their aggressive investment strategies that seek to consistently outperform the market by using a combination of long-only or long-short strategy. Some hedge funds even utilise statistical and mathematical tools and algorithms to engage in short-term trades that achieve astounding returns.
Debt to Equity Ratio
Used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.
Profit is the financial benefit realized when revenue from a business is higher than the costs and taxes involved in operating that business.
Alternative investment class composed of funds that invest directly in private companies or that buy public companies and take them private
Time of declining economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and sales.
A stimulus package is a coordinated effort by the government to increase spending and investment to "stimulate" an economy out of a downturn.
Shorting a stock
Trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
Market-capitalization-weighted index tracking the performance of the 500 largest U.S. companies