Financial Leverage Financial leverage is the act of investing borrowed capital to achieve higher return on investment. Investors use a variety of financial instruments to create financial leverage. Such financial instruments include but are not limited to futures, options, and margin accounts. Using financial leverage can magnify investor's gains, but it is also very risky, because if the market goes the wrong way, the investor's losses will be amplified as well. Buying on margin is a classic financial leverage example and is a concept familiar to most investors. The buying on margin involves investing with borrowed capital. An investor opens margin account with a brokerage, and deposits an initial amount of cash in the account. The investor then proceeds to buy securities with the option to borrow certain percentage of the purchase securities' price. This way the investor multiplies the potential gain they may achieve by using leverage. The broker lends the investor money, while using the securities that the investor buys and cash as a loan collateral. If the value of the equities bought on margin drops under certain threshold, the broker will issue the so-called "margin call" requiring additional cash deposit or selling a part of the stock. The margin account holder pays interest on the loan, and this is one of the reasons why margin buying is used for quick, short-term trades. Financial Leverage Example We will use a margin account as an example of how exactly does financial leverage work. John goes to his brokerage and opens a margin account, depositing $15,000 Canadian dollars. The brokerage allows John to borrow up to 40% of the purchase price of the securities he's planning to buy, which means that John can actually spend more than the actual cash he deposited for a total of $25,000. If John buys securities for less than the amount he has on deposit ($15,000), he hasn't actually used borrowed funds to do that, but as soon as he buys stocks for more than $15,000, he starts using borrowed money. Lets assume that John buys 250 shares in company A at $100. By doing that John has utilized his entire cash and margin. After 2 weeks the stock price of company A doubles to $200 per share and John sells his 250 shares for a total of $50,000. The stock of company A has made a 100% jump, but the actual return on investment John has is much higher. After the stock is sold at $200, and the loan of $10,000 is repaid to the brokerage, John is left with $40,000 (not considering minimal borrowing costs here). So John started with $15,000 of his own cash, and earned $25,000 for a nice gain of a little over 166%. Financial Leverage Risks Even though financial leverage can multiply investor's gains, it can easily multiply their losses as well. What will happen if in our example below the value of the stock of company A goes down by 30%? If this happens the investor will be forced to sell at loss (margin call) and he'll get only $17,500 (250 shares at $70) back. After repaying the brokerage the $10,000 he borrowed, he'll be left with only $7,500 – a loss of 50% of his initial investment.