Leverage

In finance, leverage is any technique that is used to multiply gain or loss. Common usage of leverage is borrowing money to finance investment. For instance, let us say you bought 100 shares of stock A trading at $10. Total investment value is $1000. If the stock price increases from $10 to $15 then you have total investment value of $1500. So HPR would be (1500-1000)/1000 = .5 or 50 %. Now if you leverage your investment by borrowing money from your broker, return would be different. Let us say you borrow $1000 from Schwab and buy additional 100 shares at the same price $10 then you have total investment worth $2000. Again the stock price rises from $10 to $15. Here your total investment value becomes $3000. Subtract the borrowed fund $1000, which you will have to repay. Then you have final value of $2000. Your HPR would be (2000-1000)/1000 = 1 or 100 %. By borrowing half of your investment fund, you just doubled your return.

Case 1
100 shares at $10 = $1000 total
If stock price increases from $10 to $15
HPR = ($1500 - 1000)/ 1000 = .5 or 50 %

Case 2
100 shares at $10 = $1000
Additional 100 shares at $10 = $1000 ->borrowed fund from Schwab
Total investment value = $2000
If stock price increases from $10 to $15
HPR = ($3000 - 1000 - 1000) / 1000 = 1 or 100%

It is very important to acknowledge that leverage also works the same way in negative return. So that means if a half of your investment is leveraged then your profit or loss will be doubled. If stock price in the above declined from $10 to 5 then would have -50% return in the first case and -100% return in the second case.

Note that margin rate (interest you need to pay for borrowing fund) is not included in the calculation.

Leverage can be an excellent way to boost your return while it imposes a significant amount of risk. Shrewd investors must be careful using leverage and be willing to accept the risk that comes along.