Leverage
Investing with leverage allows investors to achieve greater exposure to the marketby borrowing money
The example below illustrates the example of using leverage in the stock market, as it is also applied on eToro.
You borrow money...
Imagine that you want to invest in Company's XYZ stock, which is currently valued at €100 per stock.
At 1x leverage (which isno leverage), you buy a €100 dollar-worth stock and you pay €100 for that stock.
At 2x leverage, you pay 1/2 of the stock's value out of your own pocket and you borrow1/2 of the value. You own a stock worth €100for which you have paid only €50, and you have a debt of €50.
At 5x leverage, you pay 1/5 of the stock's value out of your own pocket and you borrow 4/5 of the value. You own a stock worth €100 for which you have paid only €20, and you have a debt of €80.
At 10x leverage, you pay 1/10 of the stock's value out of your own pocket and you borrow 4/5 of the value. You own a stock worth €100 for which you have paid €10, and you have a debt of €90.
to be more exposed...
Now imagine that you would like to invest €100 in Company XYZ. With 1x leverage, you could exactly buy one stock at its current price. With 10x leverage however, you can buy 10 stocks, by borrowing €900.
In the first case, you own 1 stock worth €100 and thus your exposureto the market amounts to €100
In the second example, you own 10 stocks worth €100, and thus your exposure to the market amounts to €1000
In both cases, you have paid €100.
& reap extra from positive returns...
Let's have a look at the return on investments. Imagine that the stock of Company XYZ benefits an increase in valueof 5%. The stock price is hence at €105. However,...
At 1x leverage, the investor holds one stock and has invested €100. Hebenefits€5 on his investment, leading to a total return on investment (ROI) of 5%.
At 2x leverage, the investor holds two stocks and has invested €100. He benefits €10 thus an ROI of 10%.
At 5x leverage, the investor holds five stocks and has invested €100. He benefits €25, thus an ROI of 25%.
At 10x leverage, the investor holds ten stocks and has invested €100. He benefits €50, thus an ROI of 50%.
Or suffer extra from negative returns
But, investing with leverage has a major potential downside. Remember from the fundamentals that risk equals return.Since your exposure, and thus your risk increases, the risk of losing money increases as well. I'll illustrate: Imagine that the stock of Company XYZ suffers a decrease in value of 5%. The stock price falls at €95. However
At 1x leverage, the investor holds one stock and has invested €100. Heloses €5 on his investment, leading to a total return on investment (ROI) of -5%.
At 2x leverage, the investor holds two stocks and has invested €100. He loses €10 thus an ROI of -10%.
At 5x leverage, the investor holds five stocks and has invested €100. He loses €25, thus an ROI of -25%.
At 10x leverage, the investor holds ten stocks and has invested €100. He loses €50, thus an ROI of -50%.
For the sake of illustrating how dangerous leverage can be, imagine the stock of Company XYZloses 15% of its value. At 10% leverage, you lose 150% of your initial investment, that is, you lose more money than you initially had!
Conclusions
Investing with leverage can be interesting and has huge potentials for extra profits.However, as much as you can potentially win by using leverage, you can also lose it as fast. By using leverage, it is possible to quickly lose your entire investments, or even more.
Since you borrow money to enable leverage, leveraging your positions are usually not free. Financial institutions, including eToro, usuallycharge fees for leveraging positions.
