Leverage
Candlefocus EditorThe primary benefit of leverage is its ability to increase the return on investment. By utilizing a larger position than what the investor has available in their own assets, leverage can potentially result in exceptionally high returns – but only if the price of the asset moves in the desired direction. Conversely, leverage can significantly amplify any losses should the price of the asset move against the borrower’s position.
In essence, leverage is a form of risk. When used correctly, leverage can be a very useful tool that can enable a much larger total return than with investment alone. Consequently, every investor should understand how to use leverage correctly, in order to benefit from it and avoid losses.
Leverage is used in both investing and corporate finance. Investors use leverage to increase their buying power and increase their potential returns. Companies use debt to raise capital and reinvest in their operations in an attempt to increase shareholder value. Leverage can give investors access to entire markets they would not otherwise be able to afford access to, such as the foreign exchange market. Some leveraged investments, such as options and futures contracts, even allow traders to take leveraged positions with no borrowed capital at all.
It is important that leverage is managed appropriately, as misusing leverage can lead to dangerous levels of debt, or “over-leveraging”. Over-leveraging played a significant role in the 2008 Global Financial Crisis, where many companies used aggressive leverage that greatly magnified their potential losses. Therefore, leverage should be used in a controlled, thoughtful and measured manner.
In conclusion, leverage is an essential tool for investors and companies alike, as it allows them to take on larger positions and potentially increase their returns. However, leverage is also a form of risk, and if managed incorrectly, it can lead to a cascade of serious losses. Appropriate usage of leverage is essential for short-term success, and prudent risk management is key to leveraging sustainable long-term gains.