Leverage is a tool used by investors to increase their potential returns by borrowing money to invest. Essentially, leverage allows investors to use other people’s money to grow their own investments. This is done by using margin accounts, which allow traders to borrow funds from a broker in order to purchase assets.
The main advantage of using leverage is that it can amplify returns. For example, if an investor purchases $10,000 worth of stock with $5,000 of their own money and borrows the remaining $5,000 from their broker with a 50% margin requirement, they effectively have twice the buying power. If the stock rises 10%, the investor would make a profit of $1,000 on their initial $5,000 investment. However, because they only put up half of the capital and borrowed the rest, their return on investment would be 20%.
While this may seem like a great way to increase profits quickly, it’s important for investors to understand that leverage also amplifies losses. If the same stock falls 10%, the investor would lose $1,000 on their initial investment. However, because they borrowed half of the capital from their broker, they would actually lose 40% of their invested capital.
Therefore, it’s essential for investors to carefully consider the risks involved with using leverage before deciding whether or not it’s appropriate for them. It’s also important for investors to have a solid understanding of how margin accounts work and what types of securities are eligible for margin trading in order to avoid any unexpected surprises down the line.