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Learning the Basics of Leverage

Mar 14, 2008
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.
About the Author
Daegan Smith is an Expert Internet Network Marketer. "Learn How To
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