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We've all heard it before: Debt is bad. But in reality, that isn't always the case. Debt can sometimes be used to build credit, start building equity through the purchase of a new home, or even to make an investment that may yield more profit than if you invested what you had in cash.
Leveraging is when you tap into borrowed money — such as loans, securities, capital, or other assets — to make a larger investment than you could otherwise make, often with the goal of amplifying returns. Leverage can also sometimes involve investments like options that don't require borrowed money but instead enable you to control a larger position than what your cash would otherwise get you.
In other words, leverage enables you to gain higher exposure to an asset than what's proportionate to the amount you put up in cash. However, leverage can increase risk.
"While leverage can magnify returns if someone can earn more on the borrowed funds than what they cost, the opposite is true," says Robert R. Johnson, a professor of finance at the Heider College of Business at Creighton University. "Leverage [also] magnifies losses when one earns less on the borrowed funds than [what they] cost."
Here's what you need to know about what leverage is, how it works, and how it's used among investors.
How leverage works
The main components of how leverage works include:
Typically, leverage involves borrowing money, such as from your brokerage account, to invest in assets you couldn't afford to purchase outright. With some investments like options, however, you might not have to borrow money, but you're still gaining a similar type of leverage, meaning a small amount of money is essentially being used to manage a larger investment.
If the investment appreciates, your profits are amplified because you control a larger position.
Leverage isn't just about borrowing money on a one-for-one basis, like asking your friend to spot you $20 for lunch and then paying them back $20. Instead, it's often used to try to magnify returns because you're controlling a larger position than you could otherwise.
For example, buying a home often enables you to use leverage. Suppose you put in a $100,000 down payment on a $500,000 home while borrowing $400,000. If the house increases in value by 10%, it would be worth $550,000. If you sold it and paid off the $400,000 loan, you'd be left with a $50,000 profit ($150,000 - $100,000 down payment), aside from taxes and fees. Yet your $100,000 investment via the down payment gained 50%, not 10%, because of leverage. In contrast, if you didn't take out a mortgage and bought a home in cash for $100,000 and that gained the same percentage value — 10% — you would only have a 10% gain.
The flip side of leverage is that if your investment declines, it can magnify losses (though in some cases like options your downside might be limited). Suppose, however, you put in $1,000 in a stock and borrowed $5,000 to also invest in that stock, so $6,000 total. If the stock drops by half to a total value of $3,000 and you sold it, you'd still have to pay back the initial $5,000 amount borrowed (plus any fees), so you'd owe $2,000 while losing the whole $1,000 you initially invested.
In other words, leverage magnified losses from $500 (if your $1,000 investment was cut in half) to $3,000 (based on losing your $1,000 investment and owing $2,000 more than the stock sale proceeds).
There are several ways to use leverage in investing, such as:
Margin trading involves borrowing money from your broker to invest, which can help you potentially magnify returns but also creates the risk of magnified losses. Plus, if you open a margin account, you'll face interest charges and risks such as margin calls, which could involve your broker selling securities on your behalf if the value of your investments drops and you don't have cash to add.
Within brokerage margin accounts, a 2:1 ratio is often used, explains Brian Stivers, an investment advisor and founder of Stivers Wealth Management. Stivers provides the following example: You can purchase $10,000 in stock by putting $5,000 of your own money into the account, and borrowing the other $5,000 from the broker using the stock and cash as collateral.
"Let's say the value of the stock rose 30%, and you sold the stock for $13,000," says Stivers. "You would then pay the broker back $5,000 leaving you with $8,000. So, you made a $3,000 profit on your $5,000, which is a 60% gain. Had you just purchased $5,000, you would have only increased your value by $1,500 for a 30% gain."
As you can see, using leverage enabled you to purchase more of the desired stock and enjoy greater gains. "But beware, if the value of the stock goes down you are also exponentially increasing your loss potential as well," says Stivers.
Quick tip: Buying on margin is a strategy that's typically reserved for aggressive, experienced investors, as there's great risk involved. Newer, inexperienced investors are generally advised not to buy on margin.
You don't have to borrow money to take advantage of leverage with options trading. An options contract often lets you effectively control 100 shares for a fraction of the cost. For example, you might spend $100 on a call option for a stock priced at $100, and with a strike price of $101. If the stock goes up to $110, you effectively gain $900 ($110-$101 x 100 shares), minus the $100 premium. But without this leverage, if you bought one share for $100, you would have only gained $9.
The risk, however, is that your option will expire worthless, meaning there's no value in converting the option into those 100 shares. So, you could lose the premium you paid to purchase the options contract.
Futures contracts provide leverage similar to the way options do, except the size of the leverage varies by the underlying asset being traded. For example, the standard size of a futures contract for crude oil is 1,000 barrels. Rather than buying 1,000 barrels for tens of thousands of dollars, you can generally pay a fraction of that amount, such as around 10%, in what's known as the margin requirement. Yet you can still gain or lose based on if you owned 1,000 barrels of oil.
Some ETFs don't require you to borrow money to gain leverage, as the fund itself uses borrowed money or derivatives to try to amplify returns. For example, an ETF might gain exposure through loans or futures to the equivalent of 2x the daily performance of a stock or index. On days the underlying asset does well, you can gain about twice as much as if you bought a comparable non-leveraged ETF, but on days it goes down, you lose about twice as much.
Using leverage offers several possible advantages, such as:
"When making a purchase, investors can use a combination of both their own equity capital and leverage to expand the affordability of any investment," says Keith Carlson, CEO and managing partner of Roebling Capital Partners. "Simply put, debt and equity availability will always be greater than equity alone; what one can purchase using both will always be more substantial."
Having more buying power through leverage isn't necessarily just used to take on risk. Some investors do so to spread out their investments across multiple asset classes to try to increase diversification while still gaining the potential for amplified returns. Also, leverage through futures and options can help you diversify in the sense of betting on different scenarios, like buying puts to protect against the possibility of a stock market downturn.
While leverage can provide several benefits, there are also significant risks to be mindful of, such as:
While leverage can amplify returns, it can also increase the potential for magnified losses, especially when using borrowed funds. For example, if you invest $100 and borrow $900 to buy $1,000 worth of stock, a 10% loss costs you $100 — yet if you just invested $100 without borrowing money, a 10% loss would have only cost you $10. So losses are amplified by 10x in this scenario.
If you trade on margin through a broker, you could face the risk of margin calls. That occurs when brokers require you to add cash or securities to your account or sell off assets to increase the equity in your margin account to a sufficient level. So, if your investments lose value, your equity could fall below the minimum and you could be forced to sell assets at inopportune times.
Overall, using leverage is more complex than investing cash. You have to understand what's at risk and nuances like the potential for margin calls before getting involved, and it can be a lot to keep track of.
Leverage isn't for everyone, but in some situations it makes sense. In general, it's meant for more advanced investors, but some factors to consider include:
If you have a high risk tolerance, you might be more willing to use leverage, but only if you can afford the potential for amplified losses. Also, you need to be able to withstand more dramatic swings in prices — including the risk of margin calls — considering leverage magnifies moves in both directions.
"If you try to magnify your returns by using leverage, you may not have the financial wherewithal to withstand the interim volatility before the wisdom of your decisions pan out," says Johnson.
Your investment goals also affect whether or not you should use leverage. For example, you might have an aggressive risk tolerance, but that doesn't mean leverage aligns with your investment goals, like saving for retirement.
Instead, you might be better off with a strategy like investing in index funds that historically gain an average of around 8-10% per year, which can put you on track to retire with enough money. In this case, leverage adds unnecessary risk, as it's not really needed to reach your investment goal.
The decision to use leverage or not can also depend on market conditions at the time. For example, after a stock market crash, you might be willing to bet that there will be a strong recovery, and you might use leverage to try to amplify returns. Of course, the risk remains that you don't really know when the crash is over and how long the recovery will last, so using leverage could result in even larger losses.
Your overall financial situation also has a strong effect on whether or not to use leverage. For example, if you don't have much in savings to afford the risk of a margin call, then it's probably not a good idea to use margin to gain leverage.
In other cases, if you have a lot of money tied up in one area of the market, you might use leverage such as through options to try to diversify and/or hedge your bets, while still being conscious of the risks.
Leverage isn't just used for investing. Some other types include:
A business can tap into leverage by way of taking out loans or issuing bonds. This can be more beneficial for a company that doesn't have a lot of assets or wants to avoid having to sell the company's equity to raise money. And in turn, leverage can be used to do a number of things: expand operations, buy inventory, materials, or equipment, or to kick-start new ventures.
This is called financial leverage, which is when a company takes on debt to buy assets that it expects to yield profits that will exceed the cost of what it borrowed.
While leverage is often associated with investing, individuals also use leverage to make big-ticket purchases. When people take out a loan to purchase an asset or with the hopes of growing their money in the future, they are using leverage.
For instance, if you take out a loan to invest in a side business, the investment you pour into your side business could potentially help you earn more money than if you didn't pursue your venture at all or if you only invested a small amount of cash.
How much leverage is too much?
The right amount of leverage varies by investor and situation, but in general, too much leverage is when the potential losses exceed your ability to cover those losses.
What are the margin requirements for different types of investments?
Minimum margin requirements vary significantly among different types of investments. For stock investments, for example, the initial margin requirement is generally 50%, and after that the minimum amount of equity needed, known as maintenance requirement, is 25% under FINRA rules. But your broker may have higher requirements. For other investments like futures, margin requirements vary but are often in the ballpark of 3-12%.
How can I manage the risks of leverage?
To manage the risks of leverage, don't invest more than you can afford to lose — including losses amplified by leverage — have an exit strategy, maintain diversification, and keep a close eye on your leveraged positions.
This Business Insider article was legally licensed by AdvisorStream
What is Leverage in Investing?
Leveraging is when you tap into borrowed money — such as loans, securities, capital, or other assets — to make a larger investment than you could otherwise make, often with the goal of amplifying returns. Leverage can also sometimes involve investments like options that don't require borrowed money but instead enable you to control a larger position than what your cash would otherwise get you.
In other words, leverage enables you to gain higher exposure to an asset than what's proportionate to the amount you put up in cash. However, leverage can increase risk.
"While leverage can magnify returns if someone can earn more on the borrowed funds than what they cost, the opposite is true," says Robert R. Johnson, a professor of finance at the Heider College of Business at Creighton University. "Leverage [also] magnifies losses when one earns less on the borrowed funds than [what they] cost."
Here's what you need to know about what leverage is, how it works, and how it's used among investors.
How leverage works
The main components of how leverage works include:Borrowed capital
Typically, leverage involves borrowing money, such as from your brokerage account, to invest in assets you couldn't afford to purchase outright. With some investments like options, however, you might not have to borrow money, but you're still gaining a similar type of leverage, meaning a small amount of money is essentially being used to manage a larger investment.
Magnified returns
If the investment appreciates, your profits are amplified because you control a larger position.
Leverage isn't just about borrowing money on a one-for-one basis, like asking your friend to spot you $20 for lunch and then paying them back $20. Instead, it's often used to try to magnify returns because you're controlling a larger position than you could otherwise.
For example, buying a home often enables you to use leverage. Suppose you put in a $100,000 down payment on a $500,000 home while borrowing $400,000. If the house increases in value by 10%, it would be worth $550,000. If you sold it and paid off the $400,000 loan, you'd be left with a $50,000 profit ($150,000 - $100,000 down payment), aside from taxes and fees. Yet your $100,000 investment via the down payment gained 50%, not 10%, because of leverage. In contrast, if you didn't take out a mortgage and bought a home in cash for $100,000 and that gained the same percentage value — 10% — you would only have a 10% gain.
Magnified losses
The flip side of leverage is that if your investment declines, it can magnify losses (though in some cases like options your downside might be limited). Suppose, however, you put in $1,000 in a stock and borrowed $5,000 to also invest in that stock, so $6,000 total. If the stock drops by half to a total value of $3,000 and you sold it, you'd still have to pay back the initial $5,000 amount borrowed (plus any fees), so you'd owe $2,000 while losing the whole $1,000 you initially invested.
In other words, leverage magnified losses from $500 (if your $1,000 investment was cut in half) to $3,000 (based on losing your $1,000 investment and owing $2,000 more than the stock sale proceeds).
Types of leverage in investing
There are several ways to use leverage in investing, such as:
Margin trading
Margin trading involves borrowing money from your broker to invest, which can help you potentially magnify returns but also creates the risk of magnified losses. Plus, if you open a margin account, you'll face interest charges and risks such as margin calls, which could involve your broker selling securities on your behalf if the value of your investments drops and you don't have cash to add.
Within brokerage margin accounts, a 2:1 ratio is often used, explains Brian Stivers, an investment advisor and founder of Stivers Wealth Management. Stivers provides the following example: You can purchase $10,000 in stock by putting $5,000 of your own money into the account, and borrowing the other $5,000 from the broker using the stock and cash as collateral.
"Let's say the value of the stock rose 30%, and you sold the stock for $13,000," says Stivers. "You would then pay the broker back $5,000 leaving you with $8,000. So, you made a $3,000 profit on your $5,000, which is a 60% gain. Had you just purchased $5,000, you would have only increased your value by $1,500 for a 30% gain."
As you can see, using leverage enabled you to purchase more of the desired stock and enjoy greater gains. "But beware, if the value of the stock goes down you are also exponentially increasing your loss potential as well," says Stivers.
Quick tip: Buying on margin is a strategy that's typically reserved for aggressive, experienced investors, as there's great risk involved. Newer, inexperienced investors are generally advised not to buy on margin.
Options trading
You don't have to borrow money to take advantage of leverage with options trading. An options contract often lets you effectively control 100 shares for a fraction of the cost. For example, you might spend $100 on a call option for a stock priced at $100, and with a strike price of $101. If the stock goes up to $110, you effectively gain $900 ($110-$101 x 100 shares), minus the $100 premium. But without this leverage, if you bought one share for $100, you would have only gained $9.
The risk, however, is that your option will expire worthless, meaning there's no value in converting the option into those 100 shares. So, you could lose the premium you paid to purchase the options contract.
Futures contracts
Futures contracts provide leverage similar to the way options do, except the size of the leverage varies by the underlying asset being traded. For example, the standard size of a futures contract for crude oil is 1,000 barrels. Rather than buying 1,000 barrels for tens of thousands of dollars, you can generally pay a fraction of that amount, such as around 10%, in what's known as the margin requirement. Yet you can still gain or lose based on if you owned 1,000 barrels of oil.
Leveraged ETFs
Some ETFs don't require you to borrow money to gain leverage, as the fund itself uses borrowed money or derivatives to try to amplify returns. For example, an ETF might gain exposure through loans or futures to the equivalent of 2x the daily performance of a stock or index. On days the underlying asset does well, you can gain about twice as much as if you bought a comparable non-leveraged ETF, but on days it goes down, you lose about twice as much.
Benefits of using leverage
Using leverage offers several possible advantages, such as:
Amplified returns
One of the main reasons to use leverage is to try to amplify returns. With a small amount of money, you can possibly gain the returns comparable to investing a much larger amount.Increased buying power
Leverage also gives you increased buying power, which is why it can provide amplified returns, but that isn't always the main goal. For example, when buying real estate, a mortgage gives you leverage to afford a more expensive home than if you paid in cash. Even if you could afford to buy the full asset in cash, you might prefer to use leverage so that you still have some buying power to put toward other assets."When making a purchase, investors can use a combination of both their own equity capital and leverage to expand the affordability of any investment," says Keith Carlson, CEO and managing partner of Roebling Capital Partners. "Simply put, debt and equity availability will always be greater than equity alone; what one can purchase using both will always be more substantial."
Diversification
Having more buying power through leverage isn't necessarily just used to take on risk. Some investors do so to spread out their investments across multiple asset classes to try to increase diversification while still gaining the potential for amplified returns. Also, leverage through futures and options can help you diversify in the sense of betting on different scenarios, like buying puts to protect against the possibility of a stock market downturn.
Risks of using leverage
While leverage can provide several benefits, there are also significant risks to be mindful of, such as:
Magnified losses
While leverage can amplify returns, it can also increase the potential for magnified losses, especially when using borrowed funds. For example, if you invest $100 and borrow $900 to buy $1,000 worth of stock, a 10% loss costs you $100 — yet if you just invested $100 without borrowing money, a 10% loss would have only cost you $10. So losses are amplified by 10x in this scenario.
Margin calls
If you trade on margin through a broker, you could face the risk of margin calls. That occurs when brokers require you to add cash or securities to your account or sell off assets to increase the equity in your margin account to a sufficient level. So, if your investments lose value, your equity could fall below the minimum and you could be forced to sell assets at inopportune times.
Increased complexity
Overall, using leverage is more complex than investing cash. You have to understand what's at risk and nuances like the potential for margin calls before getting involved, and it can be a lot to keep track of.
When to use leverage (and when to avoid it)
Leverage isn't for everyone, but in some situations it makes sense. In general, it's meant for more advanced investors, but some factors to consider include:
Risk tolerance
If you have a high risk tolerance, you might be more willing to use leverage, but only if you can afford the potential for amplified losses. Also, you need to be able to withstand more dramatic swings in prices — including the risk of margin calls — considering leverage magnifies moves in both directions.
"If you try to magnify your returns by using leverage, you may not have the financial wherewithal to withstand the interim volatility before the wisdom of your decisions pan out," says Johnson.
Investment goals
Your investment goals also affect whether or not you should use leverage. For example, you might have an aggressive risk tolerance, but that doesn't mean leverage aligns with your investment goals, like saving for retirement.
Instead, you might be better off with a strategy like investing in index funds that historically gain an average of around 8-10% per year, which can put you on track to retire with enough money. In this case, leverage adds unnecessary risk, as it's not really needed to reach your investment goal.
Market conditions
The decision to use leverage or not can also depend on market conditions at the time. For example, after a stock market crash, you might be willing to bet that there will be a strong recovery, and you might use leverage to try to amplify returns. Of course, the risk remains that you don't really know when the crash is over and how long the recovery will last, so using leverage could result in even larger losses.
Financial situation
Your overall financial situation also has a strong effect on whether or not to use leverage. For example, if you don't have much in savings to afford the risk of a margin call, then it's probably not a good idea to use margin to gain leverage.
In other cases, if you have a lot of money tied up in one area of the market, you might use leverage such as through options to try to diversify and/or hedge your bets, while still being conscious of the risks.
Other types of leverage
Leverage isn't just used for investing. Some other types include:
Financial leverage
A business can tap into leverage by way of taking out loans or issuing bonds. This can be more beneficial for a company that doesn't have a lot of assets or wants to avoid having to sell the company's equity to raise money. And in turn, leverage can be used to do a number of things: expand operations, buy inventory, materials, or equipment, or to kick-start new ventures.
This is called financial leverage, which is when a company takes on debt to buy assets that it expects to yield profits that will exceed the cost of what it borrowed.
Using leverage for personal finances
While leverage is often associated with investing, individuals also use leverage to make big-ticket purchases. When people take out a loan to purchase an asset or with the hopes of growing their money in the future, they are using leverage.
For instance, if you take out a loan to invest in a side business, the investment you pour into your side business could potentially help you earn more money than if you didn't pursue your venture at all or if you only invested a small amount of cash.
FAQs about leverage
How much leverage is too much?
The right amount of leverage varies by investor and situation, but in general, too much leverage is when the potential losses exceed your ability to cover those losses.
What are the margin requirements for different types of investments?
Minimum margin requirements vary significantly among different types of investments. For stock investments, for example, the initial margin requirement is generally 50%, and after that the minimum amount of equity needed, known as maintenance requirement, is 25% under FINRA rules. But your broker may have higher requirements. For other investments like futures, margin requirements vary but are often in the ballpark of 3-12%.
How can I manage the risks of leverage?
To manage the risks of leverage, don't invest more than you can afford to lose — including losses amplified by leverage — have an exit strategy, maintain diversification, and keep a close eye on your leveraged positions.
