Leverage has a bad name at the moment, and deservedly. Warren Buffet calls it “the only way a smart person can go broke” and is not too kind about the idea of people who aren’t smart using it, either. Leverage was also the way in which many sound businesses became suddenly poor as the downturn turned sharply against them.
Leverage is like a sharp cooking knife – incredibly effective when you are doing what you want to do but rather dangerous when you are being careless. Leverage can dramatically increase returns. If you were to put in £5,000 of your own money into an investment, and have £15,000 leant by the broker then you would be four times more exposed to price movements. So if your investment moved up by a respectable but not exciting 4%, your gain would be a far more impressive 16%. Obviously if the price went down by 4% the loss would be equally as impressive.
Contracts for difference allow for leverage in two ways. Firstly they can be bought or sold on a margin, like shares but unlike spread bets. This means that for a good customer a broker may extend a line of credit although this is not going to be available to all clients and for those clients that do get this extended they are vulnerable to “margin calls” when a holding goes below a certain amount and the broker insists on money being advanced to make up for the deficit on the borrowing.
Contracts for difference and spread bets have another way to bet on the price movements that imitates leverage, and that is to buy or sell at prices that are “out of the money”, that is that are quite a way above or below the price currently offered. These will be considerably cheaper than prices closer to the market price as many counterparties or betting exchanges will see this as a way of taking easy money.
A note of caution when using leverage, although it’s a powerful tool it should not be used for a core holding in a portfolio. If used for backing hunches but as a small part of any portfolio it can be a very good way to profit from stock market movements. If used to juice up a core holding it can make an investor very rich – or lead to the bankruptcy court.