What is financial leverage? Unveiling the double-edged sword in the stock market

Leverage Investment: The Secret to Small Capital Driving Big Returns

The core concept of leverage trading is actually very simple—“borrowing money to invest.” Imagine you have only 100,000 yuan but want to invest in assets worth 1 million yuan. At this point, you need to borrow 900,000 yuan from a broker or bank. This practice is called using leverage. In financial terms, you are engaging in financial leverage operations.

This principle originates from Archimedes’ famous statement: “Give me a place to stand, and I will move the Earth.” In the financial markets, the power of leverage is indeed astonishing—it amplifies your investment capacity, allowing small funds to participate in large-scale trades.

However, it is worth noting that leverage is like a double-edged sword. When the market reverses, not only can profits vanish into thin air, but the principal can also disappear instantly. Therefore, understanding how leverage works, mastering risk control techniques, is crucial for every investor.

How to Operate Leverage in Practice

Common leverage tools used by investors include margin buying stocks, futures, options, and other derivatives. Among them, margin trading and day trading are mainstream in the stock market.

The difference between leverage and margin needs special clarification: leverage refers to the total amount of debt you bear, while margin is the collateral you must deposit to hold a position. They seem related but are actually different concepts.

Taking Taiwan index futures as an example, suppose the recent closing price is 13,000 points, with each point worth 200 yuan. The total value of one Taiwan index futures contract is:

13,000 points × 200 yuan/point = 2,600,000 yuan

In futures trading, you do not need to pay the full amount of 2.6 million yuan; you only need to pay the margin (assumed to be 136,000 yuan). The leverage multiple is then:

2,600,000 yuan ÷ 136,000 yuan ≈ 19.11 times

This means you control assets worth 2.6 million yuan with only 136,000 yuan of capital.

Actual Comparison of Leverage Returns and Risks

Profit amplification scenario: If the Taiwan index rises by 5%, your profit is: (13,650 - 13,000) × 200 yuan/point = 130,000 yuan. In other words, with only 136,000 yuan of principal, you earn 130,000 yuan, nearly a 96% return!

Loss amplification scenario: If the Taiwan index drops by 5%, your loss is: (13,000 - 12,350) × 200 yuan/point = 130,000 yuan. Your principal is almost wiped out, approaching total loss.

This comparison clearly illustrates a core fact: the higher the leverage multiple, the greater the potential gains and risks. Therefore, investors are advised to deposit as much margin as possible, reduce leverage ratios, and strictly set stop-loss points to control losses.

The Most Dangerous Risk of Leverage Trading: Liquidation

The biggest risk in leverage trading is liquidation (also called “margin call”). When the market fluctuates sharply, causing your losses to exceed the margin, and you cannot quickly replenish funds, the broker will forcibly close your position to avoid losing money, which is liquidation.

A real case worth caution: a well-known crypto trader experienced liquidation during a live broadcast in 2022 while trading Bitcoin with high leverage, losing over 10 million USD within hours. He opened a 25x leveraged long position at a Bitcoin price of $41,666. Later, when Bitcoin fell below $40,000, he tried to add more leverage to recover losses, but was liquidated again. This case reminds us that regardless of the product traded, abusing uncontrollable leverage and immature trading strategies are fatal errors.

Many young investors now often hold the mindset of “if I win, I make a fortune; if I get liquidated, just don’t add money.” But the market is cruel, and this mindset usually ends in huge losses.

Advantages and Disadvantages of Financial Leverage

Advantages of leverage investment

Improve capital utilization: The main advantage of leverage investment is that small investors can use less capital to make large investments in the market, greatly saving trading costs and improving capital efficiency.

Increase profit potential: Without leverage, the capital and trading products are equivalent. With leverage, you can trade products worth 10 times or even 100 times your capital. If profitable, the profits are multiplied accordingly.

Disadvantages of leverage investment

Increased risk of liquidation: The larger the leverage, the bigger the position size in trading. Under the same position size, higher leverage means a higher probability of liquidation.

Magnified losses: Once a trade incurs a loss, due to leverage, the loss rate is amplified. Therefore, good risk management and timely stop-loss are crucial in leveraged trading.

Details of Leverage Trading Tools

Leverage trading tools allow investors to control larger market values with relatively small funds. Mainly including futures, options, leveraged ETFs, and CFDs. Margin trading and securities lending also belong to leverage trading.

Futures

Futures are standardized contracts where both parties agree to buy or sell at a predetermined price at a specific future date. They are often used by multinational companies for hedging. Trading targets include:

• Metals: Gold futures, silver futures, aluminum futures
• Indices: Dow Jones, S&P 500, Nasdaq, Hang Seng Index
• Agricultural products: Wheat, soybeans, cotton futures
• Energy: Oil, natural gas, crude oil, coal futures

Futures contracts specify the underlying asset, price, expiration date, etc. Before expiration, traders can choose to close or roll over the position. Settlement occurs at the spot market settlement price on the settlement date.

Options

Options give the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before a certain date. Compared to futures, options offer greater flexibility—you can choose to exercise or abandon the right.

Leveraged ETFs

Leveraged ETFs are designed for active investors, with common terms like “2x leveraged ETF,” “inverse 1x ETF,” etc. These funds amplify performance during trending markets but are disadvantageous during sideways or choppy markets, making them suitable for short-term strategies.

Note that leveraged ETFs have very high trading costs—usually 10 to 15 times those of futures trading. Investors need to weigh convenience against costs.

Contracts for Difference (CFD)

CFDs allow traders to conduct two-way trading (long or short) easily without holding actual assets or complex margin financing. Unlike futures, CFDs have no settlement date, so rollover issues are avoided.

CFDs are not standardized contracts; trading conditions vary across platforms, and products are diverse with flexible contract specifications. Using margin, you can trade various global assets—stocks, precious metals, commodities, indices, forex, cryptocurrencies, etc.

For example, if a stock is priced at $113.19, and on a trading platform you choose 20x leverage, you only need to put up $5.66 to trade one share.

Practical Tips for Leverage Investment

Regardless of which leverage tool you choose, you must fully understand the risk of liquidation and prepare sufficient funds. Investors should set stop-loss points in advance, whether using 1x or 20x leverage.

Famous investor Robert Kiyosaki once said that borrowing is not necessarily a liability. If investors know how to make good use of financial leverage—using borrowed funds to increase returns, or even acquiring assets that generate rental income and continuous cash flow—it becomes an asset rather than a liability. Creating continuous cash inflow with cash is the true secret of leverage.

Moderate use of leverage is indeed a good way to increase returns, but the key is how to properly utilize borrowed funds to grow wealth. Once leverage is used, both risk and return are multiplied. Especially when applying leverage to highly volatile products, the risk of rapid liquidation is high.

Summary

Leverage is a high-risk financial tool, but it doesn’t mean that using leverage is necessarily bad. If your leverage operations are aimed at reasonably increasing returns and controlling risks, why not?

The final core advice is: Always start practicing with low leverage ratios, and never forget to set stop-losses. Begin with small-scale leverage to accumulate experience, then gradually increase your leverage ratio as your skills improve. Remember, in leverage trading, staying alive and exiting the market is more important than making a big profit in one shot.