In the finance world, leverage (sometimes referred to as gearing), is a powerful yet complex tool that can magnify the potential returns from an investment. Simply put, leverage is the technique of using borrowed money (debt) to increase the purchasing power and potential profitability of an investment beyond what a trader could achieve using only their own available capital.
The explanation is somewhat in the name – consider a physical lever, as it uses a small initial input force to create a greater output force.
The core idea is to invest in an asset with the expectation that the return on the asset will significantly exceed the cost of borrowing (i.e., the interest paid on the loan).
For a private investor, this is often done by borrowing money from a broker, using what is known as a margin account, to buy more shares than their cash balance would allow. For example, if an investor uses $10,000 of their own money and borrows an additional $10,000, they have $20,000 to invest. If the investment grows by 10%, they have made $2,000 on a $10,000 outlay (disregarding interest and costs) instead of $1,000. This is the positive effect of leverage, which gives the investor a larger footprint in the market.
Conversely, businesses also use leverage by issuing corporate bonds or taking out loans to fund major projects or acquisitions, with the same goal: for the return on the new asset to surpass the cost of servicing the debt.
Using leverage via ASX derivatives
On the Australian Securities Exchange (ASX), leverage is a key component of many derivative products, providing traders with an effective way to implement their market views while reducing the initial capital burden. Derivatives such as Options and MINI Warrants are common instruments used for this purpose.
- OPTIONS
Exchange-Traded Options (ETOs) on the ASX grant the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price by a specific date. A primary advantage of Options trading is leverage, which offers the potential to make a higher return from a smaller initial outlay compared to purchasing the underlying shares directly. This allows traders to manage their risk tolerance while tailoring strategies to suit specific market conditions and technical analysis.
- MINI WARRANTS
MINI Warrants are a lesser known derivative that are also tradeable through the ASX, and are a relatively simpler entry point for new traders. They offer solutions for both bullish and bearish positions and provide a choice of leverage while also having in-built stop losses. MINI Warrants can be traded not only on stocks but also on core commodities, index futures, and currency swaps.
| Instrument | Capital Required | P/L on +3% Move | P/L on −3% Move | Notes |
|---|---|---|---|---|
| Stock | $100,000 | +$3,000 | −$3,000 | Linear gain/loss. No leverage; full capital required. |
| MINI Warrants | $20,000 | +$3,000 | −$3,000 | Assumed 5× leverage. Same dollar P/L as stock with lower capital. |
| Call Options | $2,000 | +$1,500 | −$1,500 | Delta 0.50. Cheaper exposure; max loss capped at premium. |
Note: Table above is a hypothetical scenario example and is for illustrative purposes only
A double-edged sword
While leverage can amplify profits, it is essential to understand that it is a double-edged sword that also magnifies potential losses. If an investment performs poorly, the investor or company is still obligated to repay the full amount of the borrowed capital, which can lead to significant losses that exceed the original investment.
For an investor using a margin account, a significant drop in the value of the leveraged asset can trigger a margin call, requiring the investor to inject additional funds to cover the loss or risk forced liquidation of their holdings. Highly leveraged companies may face an increased risk of bankruptcy or default during market downturns, as high debt levels can strain cash flow. This multiplier effect of leverage is why careful risk management is a critical component of any leveraged strategy.
At TradersCircle we specialise in leverage trading – especially when it comes to ASX MINI Warrants and Options trading. We welcome any trader to open an account with us or get some in-depth education.