Leverage

Leverage is the use of borrowed money to increase the potential return on an investment. By using leverage, investors can control larger positions than their capital alone would allow. While leverage can amplify gains, it equally magnifies losses, making it a double-edged sword. In personal finance, buying a home with a mortgage is a common form of leverage. If you put 20% down on a $500,000 home and it appreciates to $600,000, your $100,000 equity has doubled to $200,000 - a 100% return on your initial investment. However, if the home's value falls to $400,000, your equity is wiped out even though the home only declined 20%. In investing, leverage can be applied in several ways. Margin accounts allow investors to borrow from their broker to buy more securities. Leveraged ETFs use derivatives to amplify the daily returns of an index. Options and futures inherently provide leverage because they control large positions with relatively small capital. Companies also use leverage through debt financing. A company that borrows to invest in growth projects can earn returns exceeding its borrowing costs, creating value for shareholders. However, excessive corporate debt can lead to bankruptcy if business conditions deteriorate and the company can't service its obligations. The risks of leverage are significant. Leveraged positions can be forced to close at the worst possible time if prices move against you and you can't meet margin calls. Leveraged ETFs suffer from decay when held for extended periods. Corporate leverage amplifies business risk and can lead to financial distress. Professional investors use leverage strategically, carefully managing position sizes and risk. For most individual investors, leverage should be used sparingly or avoided entirely. The potential for amplified losses makes leverage unsuitable for those who can't afford to lose their capital or who lack the experience to manage the additional risk.