How does Leverage Work?

The reward or risk associated with using financial leverage. The double-edged sword!

In some of our recent Coach’s Hangout videos, we discussed things like derivatives, short selling, and margin loans, all of which can be used to enhance returns. However, it’s important to know that these type of strategies typically employed leverage. This week, it occurred to me I really should record a quick video to shed some light on the fact that leverage can be a double-edged sword. What I mean by that is, sure, leverage can enhance your gains, but it can also magnify your losses. In this video, I’m going to go through an example of leverage using an easy to understand method, which is boring to invest. I’m also going to exaggerate a little bit for learning purposes, and to make a pretty boring subject a little less boring.

Suppose you had a crystal ball that you trusted and you were 100% confident that XYZ shares are going to double in value over the next week, and you had $1 million in cash sitting in your investment portfolio. How much would you invest in XYZ, keeping in mind you are 100% confident it will double in value? I bet a lot of you are thinking, “I’d invest at all. I’d invest $1 million.” Am I right? But my response to that is, that’s all? I mean, if I knew that the share price was going to double, I would rack up my line of credit. I would take a cash advance on my credit card, and I may even call my dear old dad and ask him for a loan so I could invest even more. In other words, I would use leverage. I mean, if I could borrow a million dollars, double it in a week and pay back the loan, I would’ve generated an extra $1 million in profits using somebody else’s money.

Sounds great, right? Well, here’s the other possible outcome. What if it turns out that this crystal ball was just a Halloween decoration, XYZ goes bankrupt and the share price falls to zero? I’d be out my own money, of course, but I’d also be out the money I borrowed and invested, and trust me, those lenders, even my dear old dad, would still want their money back. In other words, I would’ve lost more than I had in the first place. Now, this isn’t a video to explore whether one should use leverage or not. That all depends on the individual investor’s situation, and guidance should always be sought from a qualified professional, but I hope this video helped to shed some light on the risk associated with using financial leverage. Thanks for popping by the Coach’s Hangout, and good luck on your upcoming exams.