In the financial services industry, leverage is the use of financial instruments to help increase potential gains or losses on particular investments. In the margin context, leverage is borrowing money to purchase additional investments (“purpose credit”) or using your securities as collateral for a purpose other than purchasing additional investments (“non-purpose credit”). Individual investors, companies, or other entities may use leverage as part of an investment strategy.
Leverage and investors
Margin leverage allows investors to extend their financial reach by borrowing money to purchase additional investments, or for a purpose other than purchasing additional investments, using their securities as collateral. However, using margin leverage can involve a high degree of risk since investors may lose more funds than they deposited in their margin account.
If you buy a security on margin by putting up $5,000 and borrowing $5,000 in your margin account to purchase a total of $10,000 worth of shares, you are leveraged 2-to-1. Suppose the security price increases in value to $11,000 and you sell your shares, you can then pay back the $5,000 borrowed and keep $6,000 for a $1,000 profit. You have made a 20% return on the initial $5,000 investment, even though the security price has risen only 10%.
Conversely, if the security price drops, your losses are similarly magnified. For example, if the price dropped 10%, you pay back the $5,000 borrowed in your margin account and walk away with only $4,000 — a 20% loss on $5,000. You will also pay interest on the loan, normal commissions, and fees, which all decrease your potential return and increase your potential loss.
Whenever you purchase securities on margin, should your margin equity fall below the minimum maintenance requirement of your account, you may receive a margin call. If you do receive a margin call, you must immediately cover the call in one of three ways:
- Add funds to your account, usually from another account via electronic or wire transfer.
- Sell securities in your account.
- Add fully paid marginable securities from another account.
Please note that your broker reserves the right to sell any or all of the securities in your account without you ever receiving any notice by way of margin call or giving you an opportunity to cover the call.
Although purchasing securities on margin always carries a degree of risk, you can help manage that risk by:
- Limiting your use of leverage by not using your entire margin balance.
- Diversifying your investment portfolio.
- Monitoring the market and your investments consistent with your risk tolerance and target goals.
It is important that investors take time to learn about the risks involved in trading securities on margin, and consult their brokers regarding any concerns they may have with their margin accounts.
Leverage and corporations
Companies also borrow money to invest in future growth, purchase equipment, and more.
The degree to which a company is leveraged can be measured by calculating its debt-to-equity ratio — a company’s long-term debt divided by shareholder equity. The more long-term debt a company has, the more heavily leveraged a company is, and the riskier it is as an investment.
A company may use leverage to boost profitability. By taking on debt, a company can keep the amount of equity capital it uses small, potentially increasing its profit as a percentage of its equity. So a company may leverage itself in an attempt to increase its return on equity (ROE). Some businesses are almost always highly leveraged due to the nature of their business; for example, banks and credit card companies are by definition lenders of money and take on the debt of their customers.
When analyzing securities, it is important to be certain a company with a debt-to-equity relative to its industry can meet interest payments year in and year out. Look for companies with consistent and reliable cash-flow streams that are sufficient to cover interest payments. If something goes wrong, either with the company itself or with the general economy, a highly leveraged company can quickly become an even riskier investment. Margin borrowing may not be suitable for all investors. When you use margin, you are subject to a high degree of risk. Market conditions can magnify any potential for loss. The value of the securities you hold in your account, which will fluctuate, must be maintained above a minimum value in order for the loan to remain in good standing. If it is not, you will be required to deposit additional securities or cash in the account, or securities in the account may be sold. Please carefully review the margin agreement, which explains the terms and conditions of the margin account, including how the interest on the loan is calculated.
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