Let’s be clear about one thing- leveraging investments is not without risk. When you leverage an investment, you are borrowing to increase your potential return on that investment. That means if things don’t go your way (or someone else defaults), then it could come back to haunt you financially or even ruin your credit rating altogether!  However, the opportunity for leverage is a thing of beauty. By using leverage, you can turn relatively small amounts of money into significant gains. So before considering utilizing any leverage tactics, make sure to carefully understand how it works and weigh the pros and cons.

How leverage works in investing

Leverage is when you borrow money to invest in increasing your overall return because your initial investment is small. If used properly, it can double or triple your return. One typical example is buying a house. Most people buy real estate with a mortgage. A mortgage is a leverage. If the purchase price is $300,000, you put $60,000 downpayment. You then borrow $240,000 from the bank. Your overall position in the real estate investment is $300,000, but your investment amount is only $60,000. If the real estate price goes up by 10%. Your return is not only 10%, but your return will be ($300,000 x 10%)/$60,000=50%! Because your total investment is five times your own money, therefore your return will also be five times compared to a no-leverage investment situation.

It looks great when you gain, but when you lose, it seems very bad. If the real estate price goes down by 10%, your unrealized loss will be $300,000X10%=$30,000. It eats up 50% of your initial investment. With real estate, you don’t have to sell it. So the loss is unrealized. But with equity investing, you have to sell off the shares or top up more money to maintain the required margin.

How margin investing works

When you open a margin account, you can borrow money from the broker to start a trade. Similar to the real estate example, you increase your investment amount with borrowed money. You need to pay interest to the broker. The concept is straightforward, precisely the same as how you buy a house with a mortgage. But stocks are not liquid, and you can buy and sell anytime. Therefore the price fluctuates during the day. When your investment price drops to the point that your margin falls below the requirement, a margin call is triggered.

For example, you buy a company share at $1 per share. You have $1000 to invest. With margin investing, you borrow another $1000 from the broker. So you have 2000 shares in the company. When the share price drops to $0.5, your loss is $0.5 X 2000 = $1000. You would have lost all your money. In this case, a margin call is triggered. On the other hand, if the price increases to $1.5 per share. Your gains will be ($1-$0.5) X 2000=$1000. You doubled your money.

As you can see, margin trading increases your position. You can either win big or lose it all. For beginners, they should avoid margin investing.

In reality, the margin call will be triggered even when the margin drops to 40% or so. Individual brokers set the required margin. Both the New York Stock Exchange (NYSE) and the Financial Industry Regulatory Authority (FINRA) require that investors keep at least 25% of the total value of their securities as margin. So what happens when your margin drops to the minimum requirement? You have to top up with the money to maintain the margin or sell part of the investments to reach the margin.

Assume the minimum margin is 35%. You bought 2000 shares of company X with a share price of $1. You invested $1000, and you borrowed $1000. So your margin is $1000/$2000=50%.

Total investment value: $2000

Your equity: $1000

Loan $1000

Margin: 50%=$1000/$2000

Suppose the price drops to $0.75. Your investment from your equity will be $750. Your margin is $750/($1000+$750)=42.85%. When the price drops to $0.25.

The total investment value is $500 (2000x$0.25).

Your equity value: $250

Loan $1000

Margin: $250/$1250=20%

To meet the 35% margin, you need to have $1250X35%=$437.5 into your investment. So you will receive a margin call of $187.5 to bring your investment to the minimum margin.

In most cases, brokers can sell your shares without calling you to bring the balance back to the margin requirement.

As you can see, margin investing is a tool that can double or triple your return. However, it also has the risk of doubling or tripling your loss if you are not careful enough when using leverage in investments

Who should use leverage in investing

Using leverage in investing has pros and cons

Pros

• it can accelerate your wealth growth

• it can help you gain more returns even if you don’t have much to start with

Cons

• it can incur a significant loss in a short amount of time

• you can lose all your initial investment

I fully understand how leverage works and can take the risk that in the worst case, it won’t affect your overall network dramatically. You can consider using leverage to invest. Secondly, you need to see which type of investment you are making. If you don’t need cash urgently for real estate investment, even when the property price drops, you don’t incur any loss unless you sell it. For equity investment, especially with a margin account, your risk is much higher as the market movement can directly affect your account balance. That being said, as long as you understand the risk and the investment itself, you can make a more informed decision if you want to use leverage or not.