Leverage in the financial marketsis the technique of using borrowed or lent capital to increase the potential return on an investment.
Leverage allows the investor to operate with a larger amount of money than he has available, which increases his chances of making profits, but also of suffering losses.
How does leverage work in financial markets?
Leverage in the financial markets works through the use of financial instruments that allow the investor to control a larger amount of assets than he could buy with his own capital.
These financial instruments are called derivatives, since their value depends on or derives from the value of another underlying asset. Some of the most commonly used derivative products for leverage are:
- The contracts for difference (CFD), which are agreements between two parties to exchange the difference between the purchase price and the sale price of an asset, without the need to physically own it. The investor only has to contribute a percentage of the total value of the asset, which is called margin, and can make a profit or loss depending on the change in the price of the asset.
- The futureThese are contracts that oblige the parties to buy or sell an asset on a certain date and at a certain price, in anticipation of market fluctuations. The investor only has to provide a guarantee or deposit, which is called maintenance margin, and can obtain profits or losses according to the variation in the price of the asset.
- The optionsThese are contracts that give the parties the right, but not the obligation, to buy or sell an asset on a given date and at a given price, paying a premium or price for the contract. The investor only has to contribute the value of the premium, and can obtain profits or losses depending on the variation of the price of the asset.
What are the advantages and disadvantages of leveraging financial markets?
Leverage in the financial markets has advantages and disadvantages, which should be taken into account before using it.
Some of these advantages and disadvantages are:
Advantages
- Allows multiply the profitability of an investment, by operating with a larger amount of money than is available.
- Allows diversify the investment portfolio, by accessing a wider variety of assets and markets, with a lower initial investment.
- Allows take advantage of market opportunities by anticipating trends and movements in asset prices.
Disadvantages
- Implies assuming a higher risk, since it involves operating with a larger amount of money than the one available, which may generate losses higher than the invested capital.
- Implies paying additional costs, such as interest on borrowed capital, intermediary commissions, taxes, etc.
- Implies being subject to certain conditions and requirements, such as margin level, maximum leverage, closing of positions, etc.
What are some tips for using leverage in the financial markets?
Some tips to follow when using leverage in the financial markets are:
- Get to know y respect the investment profile, aligning the leverage level with the investor’s preferences, objectives, time horizon and risk tolerance.
- Get informed y keep up to date about the financial market, following trends, news, analyses and recommendations from experts, as well as current regulations and standards.
- Select y diversify derivatives products, choosing those that suit the strategy, the asset and the market to be traded, as well as combining different types of products, maturities and strike prices, thus reducing risk and increasing the chances of success.
- Assign y control capital, distributing the available capital among the different operations, according to their importance and contribution to the investment portfolio, as well as monitoring the margin level, effective leverage, profit or loss, etc.
- Evaluate y compare the performance of operations, measuring the result obtained by each operation, contrasting it with the established objective and with the performance of other similar operations.
- Check y adjust operations, adapting the position and leverage level, according to changes in the financial market or in the performance of operations.
