Leveraging of cash is an investment tactic to generate larger returns than would be earned investing the cash without the use of leverage. Leveraging can be thought of as using the cash as a down payment to borrow money, resulting in a larger amount available to invest. The use of leverage can significantly increase investment returns, but can also result in wipe-out levels of losses.
Function of Leverage
Using leverage is the ability to buy or control a larger value of an investment than the amount of cash invested. The amount of leverage can be described as a percentage borrowed or the ratio of leverage to cash invested. For example, if an investor puts up $10,000 cash for a $100,000 investment, the amount of leverage is 90 percent or, put the other way, the investor is using 10 times leverage.
Effects of Leverage
Leverage multiplies the gain or loss compared to paying all cash for the same investment. With 10 times leverage, if the $100,000 investment gains 10 percent to $110,000, the investor who put up $10,000 in cash has earned a 100 percent gain on the amount invested. If the investment dropped in value by 10 percent, the investor would lose 100 percent of the $10,000 invested. The $90,000 borrowed to fund the leverage would have to be paid back first, leaving the investor with nothing. Further losses would result in the investor losing more than the initial $10,000 investment.
Borrowing for Leverage
Some investment types require the investor to borrow money to make up the balance of the cost of the investment. Investment real estate is purchased with a down payment of 10 to 20 percent, and the balance is from a mortgage loan. Taking a mortgage provides the leverage. Stock investors get leverage through margin loans from a broker. In a broker margin account, an investor can borrow up to one-half of the cost of stock investments providing two times leverage.
The trading of commodity futures and foreign currencies -- Forex -- provides built-in leverage in the way the markets function. To trade in these markets, the investor puts up a predetermined margin deposit and does not need to borrow the balance. In the U.S., Forex trading provides 50 times leverage. To trade $100,000 worth of currency, the trader must deposit $2,000. Futures contracts have a specific margin deposit amount for each type of commodity traded. For example, the crude oil futures contract for 1,000 barrels of petroleum requires a trader to deposit approximately $8,000 to control a contract worth approximately $100,000.