What is leverage in stock market?
The word “leverage” is used liberally across different fields. However, in the world of capital markets, it holds a specific meaning and purpose. As an investor, you must know what it stands for and how you can employ this financial tool to make wise trading decisions.
In this article, we will help you do the same by discussing what is leverage in share markets and its respective pros and cons in detail.
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Meaning of leverage in the stock market
Financial leverage in the stock market simply refers to a form of investment where debt or borrowed money is utilised to boost returns, acquire new assets or raise capital for a business. Companies or individuals generate this debt either by borrowing money or capital from creditors while pledging to pay it off with added interest. Therefore, leveraging can also be equivalent to trading equities. When a business is labelled to be highly leveraged, it essentially indicates that it carries more debt than equity. Having this information can help you make the most suitable decisions while finalising investments.
Leveraging can be adopted for several reasons. A company might use leverage to maximise its assets’ worth, buy new equipment, or increase shareholder value. Similarly, individual investors frequently use it to augment their investment yields. If you are not comfortable using leverage directly but still wish to benefit from it, you can consider using it indirectly. But how is this possible? Invest in companies that incorporate leveraging practices in their business operations.
There are two primary aspects to leverage in stock markets: the value of the security and the interest on the loan which is borrowed. If the asset’s value soars and surpasses the loan interest, the investor or company owning the asset will obtain higher returns, i.e., they will enjoy profits. Conversely, if the asset’s value drops, the investor or company owning the asset will incur a loss.
Based on this logic, the asset must yield more returns than the interest to earn gains. To achieve a favourable outcome, companies generally use a mix of equity and debt to sponsor their operations or to raise capital. Therefore, it is crucial that you grasp the concept of leverage because it plays a pivotal role in shaping a business’s performance.
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Pros of leveraging
- With the assistance of leveraged funds, companies can access lofty investments that would normally not be available with small upfront capital.
- In trading, when the asset price increases, leverage can help increase profits substantially. Your trades become more rewarding when your initial investment is integrated with the added upfront capital.
- In short-term, low-risk circumstances demanding substantial funding, leverage utilisation works well. A company’s need for such capital on an immediate basis for an acquisition or buyout could lead to a potentially lucrative growth opportunity.
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Cons of leveraging
- Like profits, there is always a risk for heightened loss with leverage. These subsequent losses can, at times, be higher than the initial capital investment.
- Brokers and contract traders usually impose premiums, fees, and margin rates. Plus, you are obliged to maintain a margin account with a stipulated balance.
- Leveraging could get complicated. So before entering into any positions using leverage, you might have to meticulously review your fiscal situation and all the inherited risks.
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What makes leverage different from margin?
The terms leverage and margin are often used interchangeably. While they are related, it is important to remember that they are not identical. Leverage in stock markets is a debt computation used to land higher yields. On the other hand, a margin is an amount needed to enter a position based on the margin rate requirement.
Margin can be viewed as a type of leverage that uses existing cash or security positions as collateral to enhance the company’s purchase capacity. This essentially translates to the fact that margin enables you to borrow money from a lender at a fixed interest rate so that you can invest in securities, futures contracts, and positions to earn profits. While margin and leverage are unique concepts, margin can be used to generate leverage in order to elevate your purchase potential by a marginal value.
Conclusion
Financial leverage in share markets can be a valuable tool for businesses to gather funds for expansion. Likewise, it helps individual investors in their quest to maximise returns. When used judiciously, it allows you to make higher profits with a considerably smaller investment. However, like any other fiscal instrument, leverage comes with its own set of inherent risks, such as complexity, significant losses, and additional premiums and fees. So, before you use leverage as a strategy to maximise your return on investment, ensure you check all the factors before committing to any debt or trades.
