What is leverage?
Leverage is a solution that allows you to invest with a small contribution. In other words: using other people’s resources. An investor who wants to activate leverage must first obtain financing from an external entity, i.e. a broker – this role is most often played by a bank or investment fund.
Leverage is also referred to as the ratio of equity to external capital (debt) used in a given investment. In this sense of the term, any investment loan or borrowing from which the funds will be invested is actually the activation of leverage.
Example:
Mr. Jacek wants to finance the investment with a capital of PLN 5,000. The value of the investment is about PLN 250,000, which means that the trader has to use a leverage ratio of 1:50. In this way, it will obtain a quarter of a million zlotys of funding and will be able to cover the cost of the investment with only a small financial commitment.
The overriding goal of activating financial leverage is the desire to increase return on equity (ROE).
In what situations is leverage used?
Although leverage is used in various types of investments, leverage is particularly popular in foreign exchange (e.g. Forex) transactions – investors buy a currency that has the potential to increase in value, to then sell it at its peak. However, it is important to realize that even small fluctuations in the exchange rate can lead to serious losses. Operating with leverage is a high-risk venture – the higher the leverage, the greater the risk.
Another circumstance in which investors like to use leverage is trading stocks on the Stock Exchange.
How does leverage work?
If an entrepreneur does not have sufficient funds to carry out a particular investment, he or she must obtain external funds. Leverage is also used when the cost of debt is lower than the cost of using equity. And while the entrepreneur is taking on a lot of risk for obvious reasons, he also has the chance to achieve a better financial result with little effort.
The use of leverage can be compared to using actual leverage to lift a heavy load – if all goes well, we will keep the load up long enough to earn the reward for this feat (return on investment). However, if in the process of lifting we get our foot wrong, all the ballast will fall on our head, causing serious injury (financial loss).
Leverage your money step by step:
- The entrepreneur finds an investment in which he believes it is worth committing capital.
- Seeing that it is unable to make the investment on its own, or judging going it alone to be unprofitable, it seeks external financing.
- When it succeeds, it commits a portion of its funds, representing a small percentage of the investment – this amount is called a margin.
- The remainder of the contribution consists of previously raised foreign capital.
- A leveraged order is created, described as a ratio of investor funds to funds raised (e.g. 1:20 or 1:100).
Leverage effect
Leverage always has an effect, but it can be positive or negative. In the case of a positive outcome, the investor can expect significant profits and multiple returns on investment – a negative one will mean large losses. One method of calculating the leverage ratio is to use a formula in which return on equity (ROEB) is divided by return on assets (ROAO).
The use of foreign capital under certain conditions can increase the return on equity, or the ratio of gross profit to equity. The return on assets ratio, on the other hand, provides information about the company’s operating potential. If the value of the leverage ratio (ROEB/ROAO) is more than 1, there is a positive leverage effect. Under these conditions, it is efficient for a company to use foreign sources of financing.
Otherwise, we are talking about so-called. the financial mace effect – Under such circumstances, incurring additional liabilities will cause the company’s return on equity to decline.
Maximum leverage in Poland
Knowing how risky leverage is, certain restrictions have been imposed on investors, primarily to avoid inexperienced people incurring large losses. Currently, the maximum leverage level in Poland is 1:100, but this level is generally only available to professional investors – people with proven experience and a history of successful transactions. Depending on the lending institution, novice traders can expect lower leverage – up to a maximum of 1:50.
What is a negative balance? How to avoid it?
The risks associated with operating with leverage are greater the higher the leverage. It is worth keeping this in mind, as market fluctuations (e.g., currency fluctuations) relate not to the investor’s own contribution (e.g., PLN 5,000), but to the total investment (e.g., PLN 250,000). Swinging in the opposite direction from the intended direction can cause a negative balance to appear in the investment – for the entrepreneur this means financial losses.
In a similar situation, the broker will require the trader to make up the gap in the deposit. Lack of protection against loss has led many a trader to ruin – fortunately, there is no shortage of brokers’ offers on the market that protect traders from losing an amount higher than the deposit made.
Negative balance protection is simply an additional service that ensures that no matter how bad the investment turns out to be, the investor will not lose more than he invested. As a result, speculation can be attempted by almost anyone. They still take risks, but much less than without any safeguards.
It is worth noting that in some countries protection against negative balances is even required – since so much can be lost on leveraging that legislators use this kind of prophylaxis to prevent market deregulation.
Summary
Leverage is an instrument that opens up a huge range of opportunities for investors and can lead to sizable profits in a short period of time and with relatively little money. Leveraging can also be a double-edged sword. It is important to remember that even the most detailed investment analysis, backed by years of experience, does not give a sure profit. Leveraged investing is always risky, even more so if negative balance protection is not applied.
