Although it may sound strange, leverage is a concept that is fully integrated into our lives. Almost all of us have used leverage at one time or another. It basically involves buying something by going into debt.
How does financial leverage work?
Let’s look at an example with leveraged equities.
Imagine you want to buy 100 shares worth 10 euros each, you would need 1000 euros to make the purchase. However, with leverage you don’t need to have those 1000 euros but a percentage of them, for example: If the leverage is 10x (10%), I contribute 100 euros and buy shares for 1000 euros, i.e. I borrow 900 euros. These 900 euros that I borrow to buy the shares accrue an interest that I will have to pay to the broker (the company that sells me the leveraged shares), until I sell the shares.
An even easier example: When you buy a house with a mortgage, you contribute 20% of the purchase value, and the bank lends you the missing 80%, i.e. you buy a house for 100,000 euros, the bank leaves you 80,000 euros that you pay back in instalments, basically it is a leverage.
What are the advantages and disadvantages of financial leverage?
The advantages are obvious, more profitability, you can make bigger investments with the same money, this same advantage is the main disadvantage, you are making investments for a volume that can be dangerous if they go wrong, both losses and profits are leveraged, another disadvantage is that it has a cost (the interest charged by the broker).
An example of a leveraged product is a CFD, which in Spanish means contract for difference. It is basically a leveraged purchase of shares, in which you are liquidating interest in favor of the broker for the loan that they make you. If the purchased share begins to fall, you can reach the limit of the guarantee that you have put up and the broker can make a “margin call” which is to warn you that either you put up more guarantee (money) or they will close your position and you will assume the accumulated loss. Be careful with this type of product.
As a general recommendation, avoid leveraged financial products if you do not know exactly what you are doing, they are high risk products, very advanced and complex and may involve risk of bankruptcy, at futurseguros as your trusted insurance agency in Mallorca we do not offer this type of products, only insurance based savings products, these are more conservative and guaranteed products.ucts.
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