What is leverage?
We know we’ve tackled this before, but this topic is so important, we felt the need to discuss it again.
For example, to control a $100,000position, your broker will set aside $1,000 from your account. Your leverage, which is expressed in ratios, is now 100:1.
You’re now controlling $100,000 with $1,000.
Let’s say the $100,000 investment rises in value to $101,000 or $1,000.
If you had to come up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain / $100,000 initial investment).
This is also called 1:1 leverage.
Of course, I think 1:1 leverage is a misnomer because if you have to come up with the entire amount you’re trying to control, where is the leverage in that?
Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1.
The broker only had to put aside $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial investment).
Now we want you to do a quick exercise. Calculate what your return would be if you lost $1,000.
If you calculated it the same way we did, which is also called the correct way, you would have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1 leverage.
You’ve probably heard the good ol’ clichés like “Leverage is a double-edged sword.” or “Leverage is a two-way street.”
As you can see, these clichés weren’t lying.