What is Leverage? Investing Explained

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s Leverage. 

What’s it to do with finance? 

We’re not talking fulcrums and beams here, but debt. Leverage is the term for the use of money borrowed from a bank or broker to finance an investment. 

The purpose is to generate a profit that is larger than the cost of the debt, but there is, of course, no guarantee that this will be the outcome. 

One of the most popular uses of leverage is spread-betting on shares, bonds and currencies in which you take a gamble on the difference between the buying and selling price over a set period. 

Debt: Leverage is the term for the use of money borrowed from a bank or broker to finance an investment

You need only deposit a small amount of the full bet – the ‘margin’ – to open the position. On a more mundane level, when we buy a house with a small deposit and a mortgage, we are using leverage. 

The effect is that it magnifies your potential profits, but also any losses. 

What can go Wrong? 

A great deal because, regardless of whether the investment goes up or down in value, the loan must still be repaid with interest. the best known historical example of the extreme hazards of leverage was the Wall Street crash of 1929. Many ordinary people, with no previous experience of the stock market, bought shares on margin, using them as collateral for their loans. 

As panic spread, banks began to demand repayment. But investors could not raise sufficient cash to meet their obligations, as the stock market had fallen so calamitously. Millions were left ruined.

Tell me more about the use of leverage today

An increasing number of people are trading Contracts for Difference (CFDs) ‘with leverage’ or ‘on margin’ – this is despite the fact many lose money. A CFD allows you to speculate on the future movement of an asset (a bond, share, currency or commodity) or a stock market index without actually owning it. Under rules drawn up by the Financial Conduct Authority (FCA) the amount of leverage that you will be allowed to have depends on the size of the position you take. 

You can reduce the margin requirement by agreeing stop-loss limits which should limit your downside if the price of the asset tumbles.

Can investment funds use leverage?

Investment trusts – which are quoted companies that invest in shares – can use leverage, or ‘gearing’ as they tend to call it. 

The facility to borrow money allows them to take swift advantage of opportunities, with the aim of achieving a return greater than the cost of the loan. 

A highly geared trust is usually seen as more risky: its price tends to rise more sharply when the stock market is booming, but declines rapidly when the mood darkens. Information on the level of a trust’s gearing is given in its monthly factsheet available online. 

The average level of gearing is 7 per cent.

This post first appeared on Dailymail.co.uk