Leverage: Part 1

What is Leverage?

Leverage[2] as an integral part of both an institutional and individual trading strategy, multiplies gains and losses. Utilising Leverage enables one to trade a higher volume of a financial instrument whilst not requiring any additional capital to be put up.

One form of leverage simply involves borrowing money against one’s capital. Another includes using derivatives to control a higher volume of e.g. stock vs. purchasing the actual stock.

“For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.”[3]

The potential risks of leverage, especially over-leverage, have been well documented over the past 30 years, for example the speculative hedge fund Long Term Capital Management founded by John Merriweather, Robert Merton and Myron Scholes (the latter two joint Nobel Prize winners in Economics) collapsed in the ’90s partially due to a high leverage. LTCM had a peak leverage of 100:1, i.e. for every $1 of equity, they assumed $100 of ‘debt’.

[1] Margin is collateral that a customer must put up to cover the counterparty risk  assumed by, most likely, the broker providing the assumed debt. A ‘Margin Call’ occurs when the margin posted in the account is below the minimum requirement likely as a result of an adverse market movement affecting the trader.Therefore, the most apparent risk of leverage aside from, in my opinion over-leverging, is the magnification of losses. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.

[3] http://www.investopedia.com/terms/l/leverage.asp#axzz1jMVR7sm2

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