What is leverage in trade?

Leverage is a common investment strategy. This concept works where you borrow capital which becomes a source of funding when you are investing. The reason to use this is to either expand the asset base of a firm or generate a profit on risk capital. In simple terms, you use borrowed money either through financial instruments or a borrowed capital to increase returns on your investment. It works more like a debt which firms use to finance assets. Thus, if anyone refers to an investment or a company as highly leveraged, it simply means it has more debt.

How does Leverage work?

Leverage is a form of using a borrowed capital or being in debt to take a project or an investment. This method is usually sought by many large companies as well. Usually the end result is to rapidly multiply the returns of that particular investment or project. However, on the other hand, leverage simultaneously multiplies the risk of losing everything if the plan does not work well. This was the case with large companies like Toys R Us.
This strategy is used by investors to increase their investments using instruments like margin accounts and companies to leverage their assets. Therefore, rather than issuing stocks, companies rely on debt financing to invest. Similarly, if in the event investors do not like to use leverage directly, there are many alternate ways such as investing in companies who use leverage for the normal functioning of businesses.

An example of Leverage

A simple example would be where a company has an investment of $10 million from its investors. This is also known as the equity in the company. Using debt financing, the company can borrow $10 million and now has a total of $20 million to use for business operations and this will allow more opportunities to shareholders. If an automaker borrows money to build a new factory and increases the number of cars it produces, there will be an increase in the profits as well.

Special consideration

Leverage Formulas
By analyzing balance sheets, most investors can study the debt and equity of different firms which shows the amount of leverage used to run their business. They also look at other statistical information like debt to equity and return on capital to see how much capital is deployed and how much was borrowed. However, to properly analyze this, the type of leverage used must be considered like financial, combined or operating leverage.

Operating leverage is usually measured through a fundamental analysis where the degree of operating leverage is calculated by dividing the change of the percentage of the company’s earnings for each share by the change in earnings before taxes and interest over a period. You can also calculate the degree of operating leverage which if higher, shows a high level of volatility.
Measuring financial leverage is done through DuPont analysis which uses the “equity multiplier”. This method is dividing the total assets by total equity. If half of the total assets are financed by equity where the equity multiplier is 2.0, there is more financial leverage since it has larger equity.
For many, conducting analysis or reading a spreadsheet is quite a nuisance and, in such circumstances, you can buy exchange-traded funds or mutual funds that use leverage. The benefit of using this is that the research, analysis, and decisions are taken by experts and you don’t have to break your head over this.
Using Leverage in Forex

When it comes to forex trading, leverage is used to make a profit from the fluctuations in the exchange rates and the forex market is one of the highest. Brokers who handle the investor or the forex account provide investors with loans to activate leverage.
Before trading in the forex market, an investor must open a margin account with leverage which is usually 50:1 to 200:1. This depends and varies on the size of the position and the broker. What this basically means is that a ratio of 50:1 means a minimum margin requirement for the trade is 2% and this percent of the total value of trade must be in cash in the account. Usually, standard trading uses the 50:1 or 100:1 ration whereas for positions of $ 50,000 or less use 200:1.
Let’s take a case at hand. If you want to trade $100,000 with a margin of 1%, you should only deposit $1000 to your margin account. For trades like this, the leverage ratio is usually 100:1 which might make you feel that the risk is high. But it is actually less since currency prices usually change or vary less than 1% during day trading. This is because if currencies are subjected to fluctuations like equities, brokers cannot give a lot of leverage.

How Leverage Can Backfire

While leverage is used to gain more profits, there are times where it can work as a disadvantage to investors. If the currency of your trade drops down, the leverage will increase to create more losses which can result in a major catastrophe. Therefore, to avoid such mis happenings, all traders should use stop orders and limit orders to control such losses that could occur.