Leverage is using a tool, or lever, to effect a great gain with relatively little effort. In the U.S. economy, leverage is using debt to increase profit. It can turbocharge reward, but it's also highly risky. For that reason, leverage increases volatility.
The lever in financial leverage is debt. You use other people's money to allow you to control a larger investment than you could on your own. Of course, you must pay them interest for the use of their money.
You can buy stocks, government bonds, and other approved securities on margin. You borrow up to 50 percent of the security's price from your brokerage firm, a 2:1 leverage ratio. Before you can do that, you've got to set up a margin account with at least $2,000 in it.
The advantage is that you can use all the money in your account plus the borrowed funds to buy the stock. The money in your account gives you the leverage, through the loan, to buy more stock than you could on your own.
Until you sell the security, the only cost to you is the interest on the loan. If the stock price goes up, you've made a better profit, thanks to the borrowed money.
The disadvantage, and it's a big one, is what happens if the stock price drops. Then, you've got to scramble to get additional cash to pay back the loan.
You might think, "Well, I just won't sell it until the stock price recovers." There are two reasons why you can't do this. First, you're paying interest the entire time you hold the stock. So, buying on margin is best for short-term stock purchases. That requires you to time the market, and that's almost impossible to do.
Second, the value of your loan must never be higher than 65-75 percent of the assets in your account. If the stock's price drops enough, your broker will ask you to put more cash into the margin account to maintain the margin.
After the margin account is set up, the debit amount generally cannot exceed 75 percent of the total value of the assets. But most brokers won't let the borrowed amount reach that level.
Once the margin loan exceeds 65 percent or 70 percent of the total assets, the broker will ask you to deposit more cash in the account. If you haven't got the cash, the firm might liquidate your entire account.
If the stock price falls 50 percent, you've just lost 100 percent of your investment. If it falls further, you could wind up losing more money than you initially invested.
It's similar to buying a car or home, only in this case you're buying a stock. Your "down payment" is the amount of cash in the account. The "loan" is 50 percent of the stock price. Housing prices can fall below the value of the mortgage, just like stock prices can fall. The big difference is that the bank won't foreclose no matter how far the housing price falls, as long as you keep making payments. The broker will "foreclose," or make a margin call if the loan exceeds 70 percent of the assets in your margin account.
Commodities futures trading uses even more leverage. Instead of borrowing 50 percent, you can borrow between 90 and 95 percent of a futures contract. This translates to roughly a 15:1 ratio. The minimum contract is for $25,000 or more, and the contracts are often longer term. Most businesses don't want to keep their cash tied up that long for just one contract.
Commodities futures contracts were initially set up to benefit farmers, who could sell their crops in advance. These gave them the cash to plant the crops and a guaranteed price.
Leverage is used the most in forex trading. Exchange rates change very little, around 1 percent, during the day. The extra leverage is safer with these than with stocks, where prices can jump 10 times as much.
Thanks to these high levels of leverage, most of the forex trading is done by traders seeking to generate a profit from changes in the currency values between countries. Like stocks, you'd first open a margin account. If you deposit just $1,000, you can trade $100,000 of currency, giving you a 100:1 leverage ratio. Of course, the risk is also that much greater. Most traders use strict stop-loss orders to sell the trade if the exchange rate goes against them. It's advisable for most small traders to be content with a 50:1 leverage ratio.
A leveraged buyout is when an investor, usually a company or private equity firm, takes out a loan to purchase another company, one that's much bigger. The company uses its assets as some of the collateral for the loan. More importantly, it promises to use collateral from the target company. This allows a smaller company to borrow enough to purchase a much bigger company.
When the buyout is successful, the debt is put onto the books of the target. It allows the acquiring company to remain virtually risk-free.
The operating leverage is how well a company uses its fixed cost assets, like machinery, equipment, and even salaries of software developers, to create a profit.
A company that has a lot of fixed assets, like an auto manufacturer or newspaper, has high operating leverage. Once its revenue is greater than that fixed cost, the rest is pure profit. It can leverage its fixed assets to increase its profitability greatly when times are good.
But this high operating leverage also means that, when the economy slows down, its risk is much greater. It's always got to bring in enough revenue to pay for its high fixed cost.
A company that has a lot of variable costs, like labor-intensive Walmart, has low operating leverage. It's fixed costs, such as the stores, are a small percentage of its overall costs. Instead, most of its costs rise along with sales. In other words, the more it sells, the more products it must buy and the more stockers, checkers, and managers it must hire.
Even consumers traditionally prefer credit and loans. The Great Recession created a shift in consumer spending trends. It forced them away from credit cards, using debit cards, checks, or cash to make sure they could afford their purchases. They also took advantage of low-interest rate loans to buy cars and get an education.