Leverage - One Of The Main Features Of Futures

Investing on the stock exchange, on the international Forex market and on other markets using various investment instruments requires knowledge, experience and the ability to use various tools. They also include financial leverage.

Leverage or financial leverage - these are almost magical words for those who start their adventure with the derivatives market. Leverage is also a feature that is the main factor behind the significant rotation of participants in this market.

Definition

Leverage - one of the main features of futures contracts - in the long run is primarily suitable for portfolio diversification and should be dosed in moderation.

This is a mechanism that allows you to achieve high profits using relatively small capital outlays. Importantly, for this to happen, the investor must use external financing, i.e. find an entity that will help multiply the funds that are the investment force. Who is it most often? Funds are obtained, for example, from banks granting loans in a fixed amount. To calculate the amount, the leverage ratio is used. An institution that agrees to support the investment by providing a specific amount receives appropriate remuneration in the form of interest on the loan. Leverage therefore helps players with less equity to enter the currency markets.

Leverage is a way to increase equity, but whether it will be possible to use it depends on the lending institution.

Leverage effect

What effect can we talk about when we mean the financial leverage tool? It all depends on whether it helped the investment, generated more profits, or rather contributed to the loss of the investor. The effect is positive or negative. The first one can be discussed when the return on equity increases. The second is the opposite - if the operation fails, the effect will be negative.

Formula:

Determining whether leverage has resulted in profit or loss requires the use of a formula. Thanks to it, you can determine whether the effect of its application has a positive or negative value. The obtained result is the degree of financial leverage. If the calculated value is greater than 1, it is said to be a positive effect, in the opposite situation - a negative one.

The level of financial leverage can be calculated according to the formula

Or

In order to calculate the financial leverage ratio, you first need to calculate return on equity (ROE) and return on assets (ROA), and then divide ROE by ROA.

When and where to use?

Leverage is used when investing on the Stock Exchange, as well as on the Forex market. It involves the involvement of external capital, such as loans and credits, in order to finance the company's activities. The effect of their application is to increase the profitability of the investor's equity.

In practice

In fact, it is a very simple tool for multiplying investment profits. If an investor only has 1,000 euros, pounds or dollars, which can be spent, for example, on the purchase of shares, should not expect large profits from the operation. The solution is to use leverage, i.e. external support.

The missing amount is added, for example, by a bank or other institution, thus enabling the achievement of much greater profits from the planned operation. Leverage therefore helps to multiply capital, and the loan and scheduled interest return to the lender.

It should be remembered that the higher the planned rate of return on investment, the greater the risk of the operation.

Benefits

There is no doubt that leveraged investing has many advantages. Among them are: the possibility of taking higher investment positions thanks to a significant increase in capital, the ability to invest in different classes of assets, increasing the chance for substantial profits earned in a short time, the ability to earn higher profits during periods and markets with low volatility.

What to fear?

Trading with leverage does indeed have the potential to make high profits, but if a person's prediction turns out to be wrong, then they could lose a lot more money than they invested. Leverage magnifies losses if the market moves in the opposite direction to what the trader previously assumed.

Source: Jakubczyc J.(1999). "Zarządzanie finansami. Odpowiedzialność finansowa", investing.com