What is Leverage – Introduction, Levels, Risks, and More

Introduction

Leverage is the amount of liability a company holds in combination with its debt and equity (financial structure). A company with a debt level above average for its sector benefits from a higher leverage effect.

Leverage is not necessarily bad. When there is revenue growth, it is paid off with a large surplus and additional credit is taken to take advantage of market opportunities.

However, when revenues are low, a heavily indebted business may lag in debt repayment and may not be able to borrow additional funds to survive.

Two ratios measure a company’s leverage: the debt-to-equity ratio and the debt-to-equity ratio. Comparing these ratios with other companies in the same sector gives an idea of their usefulness.

How does the Leverage Principle Work?

Leverage brings two people together: the investor, called the debtor, and the broker, called the creditor.

When the trader wants to trade leveraged, he will ask the broker to lend him some money.

This forex or stock exchange leveraged position would be possible thanks to the concept of “margin requirement. Only part of the trader’s capital is stabilize when opening a trading position called trading margin. And the remaining funds required to open this position are advance. It happens by the broker (broker). Hence the amount invest is not entirely fix in your trading account.

Leveraged investments can range from a few seconds to several days. Credit starts when the trade position is opened and is closed when the trade is close. Everything is done automatically and instantly with just one click from the trading platform.

How to Calculate Leverage?

The formula to calculate leverage level in stock trading is as follows:
Leverage Level = Position Size / Equity
Once your trade is open to the market, leverage (also used as a synonym for power) constantly changes as it depends on your equity.
• If you make a profit from your stock market position, your trading leverage falls because equities are high,
• If you take a loss on your current position, your leverage level is reduce.
Example of stock market leverage calculation:
Now that you know the formula for calculating forex leverage.

What is Leverage Level

Equity = 10,000 Euro
Position Size = 50,000 Euro
Leverage level = 50,000 EUR / 10,000 EUR = 5

Leverage Risk Management

Although leverage can be seen as a way to increase your potential profit, it should be remember that it also increases your level of risk. For this reason, it is essential to have the proper risk management rules, mainly when is used in the forex market. Here are some of the best orders that can improve your leverage management.

Stop-Loss Order

The purpose of a stop loss order is to limit the trader’s losses when the market moves against him. The trader can use this order to determine the price level beyond which he wants his position automatically closed.

Previous Stop Loss Order

Trailing stop loss orders (or trailing stop loss orders) are also intended to limit the trader’s losses when the market moves against him. But not only that, but the trailing stop loss order also secures the trader’s share of profit by following favorable price movements when the market turns in his favor.

Guaranteed Stop Loss Order

Finally, guarantee stop-loss orders (OSLG) work the same way as stop-loss orders, except they allow you to set an absolute limit to your potential loss on a given trade because they assure you that Your work will be closed at the specified time price. To take advantage of this additional protection, the trader will have to pay the commission displayed on the order ticket, which will be payable upon executing your order.

How to Calculate Leverage? (Formula)

The leverage formula is: Leverage = (Operating Income – Taxes – Financial Debt) / Equity

Operating Result

The operating result is the result related to the company’s activity. It is the difference between your business and your operating expenses (i.e., your purchases (first of raw materials, goods, service provider), salaries and social contributions).

Taxes

The tax-related here is the corporation tax which happens after the declaration of results of the company. Corporate tax for companies with a turnover of €7.63 million currently ranges from 15% to €38,120 profit. From €38,120 onwards, the corporation tax will be 26.5% in 2022, increasing to 25%.

Financial Credit

Financial debt is the amount borrow by a company from an economic actor. In most cases, financial loans consist of loans from credit institutions (banks) but can be created by company-issued bonds.

Equity

Equity is the capital of the company, which is the reserve with the company, made up of the results of the previous years in the company.

B ° / Leverage Case:

We will make three hypotheses: first with no bank loan, second with a loan of €50,000 and third with a loan of €100,000.
For the three cases, we will take the same amount in economic assets, i.e. €200,000, depending on the operating result of €20,000. For simplicity, the corporate tax rate will be 26.5%, and the lending rate will be 5%.

Leverage Risk: Examples

To illustrate the risk of leverage in real estate investing, consider the case of acquiring a rental property financed with a 20% individual contribution and 80% loan. It will be positive if the rent collected exceeds the loan fee and the property value increases. In the event of a sale, the owner will make a capital gain.

Conversely, if real estate remains vacant or if real estate market prices fall, the leverage effect will be negative and may prove dramatic, like the mortgage crisis in the United States.

In addition, an example in the stock market shows the risks associated with leverage.
In an example where the leverage is 10%, the $1,000 capital makes it possible to invest $10,000. If the stock price drops by 10% or a loss of $1,000 occur, the investor loses his entire capital.

Before resorting to a loan, it is necessary to assess its impact to ensure that the effect of leverage is beneficial to the borrower.

How do you Set up and Change the Leverage for Trading?

Log in to your client account with your broker to change the trading leverage. The client area should allow you to manage the settings of your trading account, including the level of influence.

Here’s how to open a Forex and CFD (Contract for Difference) trading account if you haven’t already. After registration, you will have access to your Trader Space, wherever you can manage your trading accounts. Admiral clients can adjust their leverage level as follows:

• From the menu, select “Edit Leverage”.
• Select the leverage you want.
• Click “Edit Leverage” to finish.

Conclusion

In the stock market, there is a possibility to acquire deferred payment securities and complex derivative products. It allows the trader to invest an amount higher than his initial bet. However, it would be best to be careful because the risk of losing capital is real.

In addition, there is a limit to the effect of leverage; It is the repaying capacity of the economic actor. Simply put, maximum indebtedness is calculated based on expect cash flows: the maximum loan amount is the maximum repayable amount allow by the cash flow.

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