Leverage is powerful tool that can work for or against an investor. At a fundamental level, leverage refers to using borrowed funds to purchase or sell shares. This will become clear from the following example.

Let us assume shares of HDFC Bank are trading in the listed markets at INR 1,000 per share. If you have Rs 1,000 and you buy one share of HDFC Bank at INR 1000 per share. If the share price moves up by 10%, your return will be INR 100 or 10%. If the share price moves down by 10%, your loss will be INR 100, or the return will be -10%.

Now assume you can borrow INR 4,000 at an interest rate of 5% to invest in these shares. The potential outcomes are summarized below.

The above example shows how returns are amplified by using leverage. That is, by investing the same money, the investor’s profits can increase or decrease significantly. Given this type of outcomes, leverage is considered to be a powerful but dangerous tool for investors.

The ways in which leverage is procured can be the following.

1) Derivatives

Derivative instruments refer to Futures and Options that trade on exchanges. Futures are products that are structured instruments in which shares can be bought with some in-built leverage. Effectively by having the money to buy one share, a loan is made available to buy six or seven (this number varies across shares and other products) shares. The price of the Futures product changes in the market in the same way that an investment that was built by taking a loan to buy six or seven shares in a basket of seven or eight shares.

2) Buying shares on margin

Brokers offer loans to their clients to buy or sell shares. Investors can tap into these loans for leveraging. Unlike Futures products, investors can use these margin loans in a manner that suits their investment strategy.

3) Credit lines

This structure is similar to buying shares from brokers but instead the loan is taken from third party lender.

While the above sources of leverage are available to sophisticated and institutional investors, many of the above sources of leverage are also available to retail investors. Retail investors should particularly be careful and wary of using leverage because of the adverse impact it can have on portfolios when the market moves in an unfavorable direction.

 

Disclaimer: Vitspan does not provide any investment related, tax related or financial advice. The information presented is done so without considering the investment objectives, risk profile, or economic circumstances of any reader or investor. The information presented may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the potential loss of principal. Please consult your financial advisor prior to making investment related decisions.