Leverage
Borrowing to invest more than one’s stake: gains and losses are magnified.
Investing more than your stake
Leverage means borrowing to invest more than one’s capital, or using products (futures, CFDs, options) whose exposure exceeds the stake. It multiplies gains and losses alike, and can lose more than the money put in.
Leverage in companies
An indebted company also magnifies its return on equity as long as the business earns more than its cost of debt. Net debt / EBITDA measures that leverage; beyond 3 to 4, lenders get nervous.
- Leverage = total exposure / own capital
Leverage of 5
- You put in €10,000 and borrow €40,000: €50,000 of exposure.
- The asset rises 10%: +€5,000, i.e. +50% on your stake.
- The asset falls 20%: -€10,000, your stake is wiped out.
With leverage of 5, a 20% fall wipes you out.
Archegos (2021)
The family office Archegos held, through swaps with several banks, positions many times its capital. When some of its stocks fell in late March 2021, margin calls forced huge sales; banks lost more than $10 billion, about $5.5 billion of it at Credit Suisse.
Common mistakes
- Ignoring margin calls, which force selling at the worst time.
- Forgetting the funding cost, which eats into returns.
Notitia newsroom · education, not investment advice.