Market Leverage

What is Market Leverage? 

• Leverage is any technique that amplifies investor profits or losses. It describes use of borrowed money to magnify profit potential (financial leverage), but it can also describe the use of fixed assets to achieve the same goal (operating leverage). 

• Leverage is the ability to trade a large position (i.e. a large number of shares, or contracts) with only a small amount of trading capital (i.e. margin). 

• Leverage is the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

                                                         

Significance of Leverage - 

- Positive Significance

• Leverage helps both the investor and the company to invest. However, it comes with greater risk as well . If an investor uses leverage to make an investment and the investment moves against the investor, his losses can be much greater than it would've been if the investment had not been leveraged -leverage amplifies both profits and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

Negative Significance - 

• Leverage is actually a very efficient use of trading capital, and is valued by professional traders because it allows them to trade larger positions (i.e. more contracts, or shares, etc.) with less trading capital. Leverage does not change the potential profit or loss that a trade can make. Rather, it reduces the amount of trading capital that must be used, thereby releasing trading capital for other trades. For example, a trader that wanted to buy a thousand shares of stock at Rs 500 per share would only require perhaps Rs 200,000 of trading capital, thereby leaving the remaining Rs 3,00,000 available for additional trades. This is the way that a professional trader looks at leverage, and is therefore the correct way.

• Leverage can be of high risk because it magnifies the potential profit or loss that a trade can make (e.g. a one can enter a trade using Rs 100,000 of trading capital, but has the potential to lose Rs 10,00,000 of trading capital). This is because that if a trader has Rs 100,000 of trading capital, he should not be able to lose more than Rs 100,000, and therefore should only be able to trade Rs 100,000 (e.g. by buying one thousand shares of stock at Rs 100 per share). Leverage would allow the same Rs 100,000 of trading capital to trade perhaps Rs 4,00,000 worth of stock (e.g. by buying four thousand shares of stock at Rs 100 per share), which would all be at risk. 

Conclusion

The bottom line is when it comes to leverage, unless you are a professional trader and your losses will be covered by your employer, leveraged investing should probably not be our primary investment strategy. If we are not a professional and you choose to use leverage, it makes sense not to invest more than you can afford to lose. Also, be sure to conduct careful research and make sensible decisions. 

Thank You !