Leverage is the use of borrowed money to increase the size of an investment position. It allows investors to control a larger amount of an asset than they could with their own capital alone. By using leverage, small price movements can have a much bigger impact on the investor’s returns.
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Leverage amplifies both potential gains and potential losses.
When using leverage, an investor deposits a portion of the total trade value, known as margin, while the remaining amount is financed through borrowing. Gains and losses are calculated on the full position size, not only on the invested capital. This means percentage returns can increase rapidly, but losses can also grow quickly.
If the market moves strongly against the position, the broker may issue a margin call and require additional funds. Leverage can improve capital efficiency, but it significantly increases financial risk and requires strict risk management.
Short example:
Suppose an investor has $2,000 and uses 5 to 1 leverage to buy $10,000 worth of a stock index.
If the index rises by 4 percent, the total position increases by $400. Since the investor only invested $2,000, this represents a 20 percent return on their own capital.
However, if the index falls by 4 percent, the position loses $400. That equals a 20 percent loss on the investor’s capital. If the market falls by 20 percent, the entire $2,000 could be wiped out, even though the index itself only declined by one fifth.
Disclaimer: Investing brings risks. Our analysts are not financial advisors. Always consult an advisor when making financial decisions. The information and tips provided on this website are based on our analysts' own insights and experiences. Therefore, they are for educational purposes only.