Leverage: How It's Used in Investing, Business and the Economy

Risks and Rewards of Leverage

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In the movie "Arbitrage," Richard Gere's character used leverage to finance a wealthy lifestyle--until it all came crashing down. Photo by Bobby Bank/WireImage/Getty Images

Definition: 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

Financial Leverage

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. 

Stock Investing

You can buy stocks, government bonds, and other approved securities on margin. That means you borrow up to 50% 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." However, there's two reasons why you can't do this.

First, you're paying interest the entire time you hold the stock. Therefore, buying on margin is best for short-term stock purchases. That's requires you to time the market, and that's nearly impossible to do.

Second, the value of your loan must never be greater than 65-75% 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% of the total value of the assets. Most brokers, however, won't let the borrowed amount reach that level. Typically, once the margin loan exceeds 65% or 70% 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. (Source: "Margin Accounts," Wells Fargo)

If the stock price falls 50%, you've just lost 100% 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 the 50% 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% of the assets in your margin account.

 

Commodities

Commodities futures trading uses even more leverage. Instead of borrowing 50%, you can borrow between 90% - 95% of a futures contract (roughly a 15:1 ratio). That's because the minimum contract is for $25,000 or more, and they are longer term. Most businesses don't want to keep their cash tied up that long for just one contract. Furthermore, commodities futures contracts were initially set up to benefit farmers, who could sell their crops in advance. This gave them the cash to plant the crops, and gave them a guaranteed price. For more, see Are Commodities Really Risky?

Forex

Leverage is the largest in forex trading. That's because exchange rates usually change very little, around 1%, during the course of the day. The extra leverage is safer than with stocks, where prices can jump 10 times as much.

 

Thanks to these high levels of leverage, most of 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. (Source: Kesavan Balasubramaniam, How Does Leverage Work in the Forex Market? Investopedia.com)

Leveraged Buyout

A leveraged buyout is when an investor, usually a company or private equity firm, takes out a loan to purchase another company, usually one that's much bigger. The company uses its own assets as some of the collateral for the loan. More important, 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, leaving the acquiring company virtually risk-free. For more, see Leveraged Buyout

Operating Leverage

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. That's because, once its revenue is greater than that fixed cost, the rest is pure profit. It has the ability to leverage its fixed assets to greatly increase its profitability when times are good. However, this high operating leverage also means that, when the economy slows down, its risk is much greater. It's got to always 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 percent 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. 

Consumer Leverage 

Even consumers traditionally prefer credit and loans. However, since the Great Recession, they've shied away from credit cards, using debit cards, checks or cash to make sure they can afford their purchases. They've also taken advantage of low interest rate loans to buy cars and get an education. For more, see Consumer Spending Trends and How Does Your Credit Card Debt Compare to the Average?