What is leverage?

Answer 1

Leverage as it relates to financial markets is the ability to profit on a financial instrument by putting up a portion of the full amount. This portion is generally known as "Margin."

Some investment instruments allow for a deposit of "Good Faith" or Earnest Money to "control" the investment vehicle. The investor than could profit on the complete investment, having only "Put Up" a portion of the underlying value, i.e. the "Margin."

For example, in the commodities markets, let's say "The Margin" (IM short for Initial Margin) on crude oil is $3,000 per contract to leverage 1000 barrels of crude oil. Assuming the current price is $100 per barrel, you are "LEVERAGING" $30,000 worth of crude oil for a $3,000 investment. Sound Good? Not so fast. Leverage can be a double edged sword.

There is a second "Margin" term called "Maintenance Margin" (MM for Short) Once your account value hits "MM" you will get a "Margin Call" and be required to deposit more money or take your loss. In practice:

IM: $3000

MM: $2000

Crude contract 1,000 Barrels per contract = means every dollar up is $1,000 to you on $3000 investment. i.e. you have "Leveraged" the crude well.

Crude contract 1,000 Barrels per contract = means every dollar down is $1,000 loss on $3000 investment. i.e. you will receive a "Margin Call" to replace the loss, or you will be liquidated.

A fun way to see more on this concept is to watch the film, "Trading Places." The leverage (and Loss) on the Duke Brothers OJ investment results in a margin call that puts them on the street.

Although margin is prevalent in currency and commodities trading, many stock firms allow margin trading as well, with their own terms.