Learning the Basics of Leverage
Making investments is very risky. A person makes an investment
in a business or in stocks expecting to multiply the amount that
he or she has invested after some time. However, whenever
someone makes an investment he or she also has to consider the
risks and the possibility of failure.
What amount will be lost if the investment does not pay off? One
has to think about this especially if the money being invested
was acquired through loans. Nobody wants owe so much money from
banks after your investment has failed and not be able to find a
way to pay for them.
Therefore, whenever you invest your money in a business venture
or in stocks, you have to consider all the options on how to
manage your investment and the risks that come with them.
If you are investing in stocks, you might want to read and
research about leverage. Leverage is considered as one of the
most significant, yet at times not easily understood, option in
investing on stocks.
Leverage is usually defined as increasing the potential for
earning of the money invested that the amount of the initial
investment. Being defined as such, many people will definitely
be interested in knowing more about leverage.
Leverage is achieved by placing your initial investment then
borrowing some of the money to increase the capital through
loans from banks.
For example, if you will be making an investment for $100,000
and if you have a $20,000 capital, you still need $80,000 to
complete your investment. The $20,000 is your equity and the
$80,000, which you will be borrowing from the bank or someone
else, is leverage.
Leverage is called as such because it influences your
investment. Also, if initially your equity is the amount that
you have invested, equity can also be computed as the difference
between the value of the investment (business or stocks) and the
leverage, or the money that you owe. If the leverage is made
through borrowing money, there is a cost of leverage, which
could be the interest that you will pay on the loan.
So, if after one year your business or the stocks has increased
in value, say by 10%, in this case, the value will be $110,000
the following year. Since the loan balance, or the leverage did
not change in value, which is still at $80,000 (not including
the cost of leverage), you can compute the equity by subtracting
the $80,000 from the $110,000 investment value.
This will give you a difference of $30,000, which is the equity.
There has been a 50% increase in equity within one year from
$20,000 to $30,000.
In terms of stocks, you are given a stock option when you are
given the right to purchase your company's stocks at the
exercise price, which is lower than the market price. So if your
company's stock is sold to you at the exercise price of $8, and
the market price is at $10, your equity is the $2 difference. If
the market value of the stocks increases by 10% the following
year, and since your exercise cost is still the same, your
equity increases by 50%.
If you have 50,000 shares in your company's stocks, this will
mean an increase in equity by $50,000 in one year.
The leverage that you have when you were given the stock options
increases the potential of multiplying your equity. Because of
this, even small changes in the value of the stocks can increase
your earning potential.
However, with this much earning potential also comes as much
potential for losses. For instance, if your stocks decreased in
value by 10 percent, your equity will also decrease in value by
50 percent. Because of this, you have to manage your investments
wisely.
You will have to judge which stocks should you keep and which
should be sold. To do this, you have to consider the leverage.
Leverage is the key to determining which investments should or
should not be sold. You have to keep the stock options with the
most leverage. Even with a small increase in the market value of
the stocks, the option with the most leverage has the greatest
increase in value in percentage.
To compute for the leverage, just divide the exercise price with
the market price. In the example above, this will be $8 divided
by $10. Therefore, you have leverage of 80%.
Every investment has its earning potential and its risks. If you
were given stock options, knowledge of how leverage works can
increase your equity and earning potential.