Dictionary.com defines leverage as: "investing with borrowed money as a way to amplify potential gains at the risk of greater losses." It is precisely that.
I will explain this concept in relation to trading the markets with the following example.
Let's say that you have $30,000 with which you can invest. You would like to purchase Microsoft shares which are currently trading at $30 for the purpose of this illustration. Ignoring brokerage, you will be able to purchase:
$30,000 ÷ $30/share = 1000 shares.
If Microsoft shares were to rise by $1/share, then you would make $1 x 1000 shares = $1000 profit. (3.3% profit)
If Microsoft shares fell by $1/share, then you would lose $1 x 1000 shares = -$1000. (3.3% loss)
Now let's take a look at the end result if you were to use leverage. Let's say that you were able to borrow 95% in order to invest, which means that you would only have to put up 5% of the total value of the position. Contracts for Difference (CFDs) allow you to do this, however, they are not available in all countries. Options and futures are another example of this. For the sake of this illustration, I will use CFDs to demonstrate the power of leverage.
Now that you can borrow to invest, with the same $30,000, you can now purchase $30,000 ÷ 5% = $600,000 worth of Microsoft shares.
$600,000 ÷ $30/share = 20,000 shares.
Ignoring interest costs: If Microsoft shares were to rise by $1/share, then you would make $1 x 20,000 shares = $20000 profit. (66.7% Profit)
If Microsoft shares fell by $1/share, then you would lose $1 x 20,000 shares = -$20000. (66.7% Loss)
The above examples clearly illustrate the power of leverage, which allows to make huge amounts of money with very little money of your own. However, be careful of the pitfalls with using these types of instruments, as you could very easily lose more than you put in to begin with.
As a result of this, sound money management principles must be implemented when using leveraged products. I will talk about money management in my next article and why I believe good money management is essential.
By Peter Yin, TradingNewbies.com
