When a trader does not have the amount necessary for an operation that he intends to carry out anyway, or wants to avoid engaging all the availability in one hand, he can take advantage of leverage, a tool made available by brokers for similar cases.
Sometimes the hypothesis of high exposure on a financial market may arise on the markets, against an all in all modest investment of capital, for example, for the purchase of many lots, or of equity securities with a particularly high cost. If the market did not provide tools capable of bypassing this possible bottleneck, it would turn into an activity reserved exclusively for large investors, cutting out all the others. By drastically narrowing the number of potential actors, it may very soon cease to operate. That is why a series of tools have been created, which are called to democratize the market to the maximum. The key tool in this regard is leverage.
What is the leverage?
Leverage is the tool that offers traders a high exposure to a financial market against a relatively modest capital investment.
When deciding to invest in a leveraged product, the provider will ask for the payment of only a limited part of the total value of the position decided, personally putting what is left. The gain or loss that will result from the operation, however, will be based on the entire value of the position.
It follows that the amount earned or lost is very high in relation to the amount invested, going even to exceed the initial disbursement, called margin or deposit requirement. This is an amount requested by the provider in order to cover, in whole or in part, the losses that could be incurred. The margin is usually a fairly limited part of the total cost of the operation if you consider that on a less volatile market, it amounts to approximately 5%.
In practice, the broker uses leverage as a sort of promotion, allowing anyone to invest, even on a whim, however asking for a precautionary deposit, which will protect him from the suicidal drives and the obvious inability of the trader.
How does it work?
When we talk about a 10% margin, therefore, it means that by committing a hundred euros, we can get the same exposure that we would have invested a thousand. In this case, the leverage is equal to ten times the real value. For example, if we wanted to buy a thousand shares of a particular company, trusting in their growth and being quite sure about the feasibility of the operation, at the current price of one euro, the operation would involve an exposure for one thousand euro. Assuming that the price rises by 20 cents for each share, the position acquired would close with a total of one thousand two hundred euros, or with two hundred euros in earnings, 20%.
However, some providers are willing to offer the opportunity to purchase the shares in question using leverage. Under this opportunity, we can, therefore, pay a margin, or a percentage of the entire sum, in exchange for a total exposure. If the margin is set at 5%, we will always have to pay in the case that we are examining 50 euros. In the event that the profit is that already described, we would, however, collect all the two hundred euros that are guaranteed by an equity transaction carried out in the traditional way.
The main difference is that we will have made the same gain in both cases, but using the lever, we could only pay a deposit of one hundred euros, instead of the thousand that maybe we didn’t have at that moment. With the real availability, one hundred euros, we would have earned only twenty euros instead of the two hundred actually brought home.
It is necessary to be very careful without the easy enthusiasm typical of the neophyte: the lever amplifies the gains but also the losses!
This quick example serves to explain in a very concrete way and without too many words, the true usefulness of leverage. At the same time, the neophyte should not get caught up in easy enthusiasm. If, in fact, the leverage is an excellent tool that allows you to overcome the bottleneck deriving from the lack of effective resources capable of making the most of a transaction, on the other, it is always worth remembering that it is not only used to amplify earnings but also losses. If the market moves in a different way than we expected, the loss may even exceed the value of the initial deposit, and we will have to clear it anyway since it is only a loan from the broker.
The advantages of leverage
It is quite clear that the substantial advantage offered by leverage is that of allowing greater liquidity in the portfolio, deriving from the fact that only a marginal part of the real value of the assets concerned can be tied to give rise to an operation investment. With this procedure, we will be able to obtain a much higher exposure than we would have with physical possession of the securities. It is, therefore, an operation that proves to be particularly convenient for those who believe that they may have other operations at hand at the same time that could yield excellent profit margins and consequently do not want to concentrate all their capital on the one hand but diversify as far as possible.
At the same time, however, it should not be forgotten that leveraged transactions entail the renouncement of all the advantages that can characterize the actual holding of shares or delivery of the futures involved in the investment. Furthermore, it may be necessary to pay an additional margin in order to cover any losses that may occur in the unfortunate event the market proves to be unfavorable.
Those who use it know that leverage is a very powerful tool the more we understand how to manage diversification.
Maximum forex traders prefer high leverage brokers in order to amplify their exposure on the various markets, with the clear aim of maintaining greater liquidity in the portfolio, which can thus be diverted to other investments. This is precisely the advantage, a greater and better distribution of capital than what could instead be done by physically purchasing the goods.
Leverage can be used in many markets, starting with the equity market and, for example, involving commodities, bonds, indices, and much more. For those who think of using it on Forex, it should be remembered that some brokers offer a leverage that can reach 400: 1 or even higher. The level of exposure that this lever entails, however, should make us reflect on the riskiness of using it and make an adequate assessment that includes pros and cons.
Even companies are used to using this tool, in order to invest in goods from which they think they can derive a more or less high and considered safe return. Among the strategies most used by businesses, there is also that of using debt to finance activities. Clearly, the companies that do so believe that they can derive from the investments made an annuity higher than the cost of interest that they are called to pay on their debt.
A school case
Recently, there has been much analysis about the incredible leverage put in place by Goldman Sachs and other financial institutions, such as hedge funds, to finance investments that have made it possible to accumulate huge profits in the order of even 40%. These are extremely risky operations, as the figures at stake are enormous. If the market suddenly had a movement like the one that followed the bursting of the subprime mortgage bubble, the losses of those directly concerned would be so enormous that they could not be filled.
Clearly, these banks, which are usually referred to as “too big to fail,” are too large to fail, and are confident of state intervention in the unfortunate hypothesis of a route on the markets. Those who do it on Forex, on the other hand, cannot rely on state intervention and must answer personally for any forfeited losses. This is why you should use this tool carefully and only if you have a reasonable certainty of success.
Tina Johnson helped bring The Marketing Folks from a-weekly newsletter to a full-fledged news site by creating a new website and branding. She continues to assist in keeping the site responsive and well organized for the readers. As a contributor to The Marketing Folks, Tara mainly covers industry new.
