Leverage
Leverage is a financial term that allows an investor to obtain control over a position much larger than what the original capital would normally afford. That is to say, it actually involves borrowing funds-often from brokers-to make the profit any investment might generate. The leverage amplifies both gains and also enhances the likelihood of losses.
Example:
You have made an investment of ₹ 10,000 in a no-leverage stock. Your gain or loss is only related to the price movement of that stock. With 1:5 leverage, you can now control ₹50,000 with just ₹10,000. If the stock moves up by 10 percent, you gain ₹5,000 on ₹50,000. Without leverage, you would have gained just ₹1,000.
Formula:
Leverage = Total Exposure / Initial Capital
In the above example, it is 5x leverage because with ₹ 10,000 capital, exposure is created as ₹ 50,000.
Payoffs
The net result of a leveraged position after closure is referred to as payoff. A payoff can be a gain or loss, and its value depends upon the price movement of the underlying asset and leverage applied to it.
- -Positive Payoff: When the asset price moves in your favor, the payoff reflects your profits after considering the leverage. For example, if you have leveraged a buy a stock and its price went higher, then your payoff will be higher than some non-leveraged investment.
- Negative Payoff: If the asset price moves against you, the losses become bigger due to the leverage, leading towards having more negative payoff.
Benefits of Leverage:
- Leverage Returns: The first advantage of leverage is that you are amplifying your returns. The amount of money you have is relatively small, yet you can now control a larger position and thus bring in more in profit.
- Access to Larger Investments Through leverage, access to markets or investments that otherwise would be too expensive to access is possible. To illustrate this, there are many people in real estate who use mortgages--a type of leverage--to acquire properties that they would not have been able to afford paying for in cash.
- Higher Degrees of Flexibility: Leverage provides the user with a higher degree of flexibility in capital management. With the use of borrowed funds, it will be possible to employ one's own funds in various different investments and also diversify the portfolio, which may reduce risks.
- Leverage Capital Effectiveness: There, you can use the available capital to make the best use of your capital by leveraging it. Assume you have ₹100,000 in your account and you are using 10x leverage. Then, you can make control over assets worth ₹1,000,000. This will enable you to take bigger positions, while keeping the capital free for other opportunities.
- Hedging potential: A position established in derivative markets can use leverage to hedge a position using options and futures. It provides an investor with a leveraged position that would be used to level the playing field or balance possible losses in another investment.
Risks and Considerations
Leverage has a very high potential for bigger payoffs but comes with risks as well:
- Amplified Losses: Wherever leverage is concerned, gain as well as loss is amplified. A small unfavorable movement in the price of the asset can easily amplify to exceed your investment amount.
- Margin Calls: Once a position starts to deteriorate a lot in leveraged trading, you might receive a request to add more deposits to keep that position going - and this is called a margin call.
In fact, interest costs while making the higher level of positions using borrowed funds will appear in your case to be eating away your profits or increasing losses when you lose.
While using leverage increases exposure to possible payoffs, something similar marks possible risks. Proper management of those risks is important when trading with leverage.
