In this context, leverage is simply the practice of using borrowed money to make investments. Let us suppose that you have a strong feeling that a particular stock(say the stock of Goldman Sachs) is going to increase in value. You also want to earn insane amounts of money by investing in that stock but only have 1,000 dollars in your bank account.

No Leverage
Suppose that the stock (GS) is trading at 70$ per share today and you expect the value of the stock to go up to $80 in 2 months. If you invest $1000, you will be able to buy $ 1000/ $ 70 = 14.29 shares (For the sake of simplicity, assume that you can buy fractions of a share) . If the  stock does move to $80 in 2 months and you sell your shares, you will end up having 14.29 * $80 =  $1143. This is a profit of $143.

With Leverage
Suppose you borrow $2,000 from a bank and use this amount in addition to the $1,000 that you already had to buy Goldman stock, you would have $3000/$70 = 42.86 shares. At the end of 2 months, if the stock does indeed rise to $80 per share and you sell you shares, you will have 42.86 * 80 = $3429 . You will have to pay back the $2000 that you borrowed from the bank. Thus you are left with $3429 – $2000 = $1429. This is a profit of $429 , which exactly 3 times $ 143 (the profit earned in the previous case).Thus, you have effectively tripled your profit using leverage aka borrowed money.

There is no such this as a free lunch
If leverage is so great, why doesnt everybody use it? What is the downside? The answer lies in the fact that leveraged is a double edged sword. It magnifies your profits as well as your losses. Let us use the previous example to explore this assertion. If Goldman stock, instead of rising to $80 per share, fell to $60 a share and you sold your holdings, you would have had $60 * 14.28 = $856.8 which would have resulted in a loss of about $143. If you had used leverage, you would have had had $60 * 42.84 = $ 2570 which would have resulted in a loss of about $429 which is exactly 3 times the loss without leverage.

In essence, we are magnifying the exposure that we gain, to changes in asset(shares etc) prices, through the use of borrowed money.

Common forms of Leverage
The most common way people lever their trades is by using something known as margin trading. When you trade on margin, you are essentially borrowing money from your broker and investing it in the stock market/whichever market you are trading on. You typically pay interest on the borrowed money. We will talk more about margin trading later.

Though not involving the use of borrowed money, CFDs (Contracts for Difference), futures and options are other ways to magnify your exposure to movement in the prices of assets. These instruments are essentially contracts and we will deal with these instruments in later posts.

The moral of the story is – Leverage is a great tool . Use it wisely and carefully lest you lose everything including your shirt.

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