In finance, leverage refers to the ratio of debt to equity. The higher the proportion of debt, the more leverage. Leverage allows you to use a small amount of your own money to make an investment that you expect to increase in value. In that way, leverage can increase your buying power and give you control of potentially valuable assets. When you take a mortgage, you’re using leverage to pay for something you can’t buy with the cash you have on hand.
Because you’re putting up less of your own money, the return on your investment can be much larger using leverage than it would be without leverage. For example, consider buying a house $100,000 with a $20,000 down payment and an $80,000 mortgage – and selling it later for $140,000. That’s not a 40% profit ($40,000 on $100,000); it’s a 200% profit. ($40,000 on $20,000). The difference is leverage. You make profit not just on your own money but also on the money you borrowed.
But be careful, because as the saying goes, leverage works both ways.
If that same house were to drop 20% in value and you sold it for $80,000, you haven’t just lost 20% on your investment, you’ve lost 100% (-$20,000 on $20,000) in the transaction.
Today, opportunities for leverage abound. You can leverage stock investments by buying on margin. In this case, you use some of your own money and borrow the balance of the stock’s cost from your broker. Essentially all derivatives—including futures, forwards, swaps, vanilla options and exotics—provide leverage. They offer indirect interest in an underlier for an initial investment that is less than the value of that underlier. With some derivatives, such as forwards or swaps, no initial investment is required. Securities lending and repurchase agreements can be used to leverage a portfolio. In essence, they represent secured borrowing. Short selling offers leverage—proceeds of a short sale are not a loan, but they can be invested just the same.
Again, you must balance the risk and reward. While leverage can increase your return, it can also expose you to significant risk. The more volatile the investment you leverage, the greater your risk of significant losses. In fact, you can lose more than the amount you invest, which you can’t do when you pay full price.