Contents of this article
When you take out a margin loan (using margin/leverage) to buy stocks, you are using leverage to invest. So what exactly does leverage mean in the stock market?
What is leverage in the stock market?
The leverage of a brokerage account is calculated with the following formula:
As a reminder, the assets in a brokerage account consist of cash and stocks. Net asset value equals total assets minus debt, and it is the part of the assets that truly belongs to you.
If the account’s debt is zero, meaning you are not using margin, leverage = 1, and you are not leveraged. If you do use leverage, its value is always greater than 1.
What does leverage mean for your returns?
In our full article on margin, we saw that using margin magnifies both returns and risk. Leverage is the number of times your return is multiplied compared with not using margin. Let us look at the example below to see the role of leverage.
Two portfolios with the same capital of VND 700 million invest in AGG stock at VND 40,000. The first portfolio uses no margin, while the second borrows VND 300 million on margin. After a while, the share price rises to VND 50,000; the two portfolios’ returns are shown below:
In the second portfolio, leverage is 1,000/700 = 1.43, and its return is exactly 25% × 1.43 = 35.7%. So the value of leverage is the number of times your return is multiplied.
In a worse scenario, where the share price falls to VND 30,000, your loss is also magnified 1.43 times.
Leverage used = 1,000/700 = 1.43
In general, your return when using margin is related to leverage as follows:
Return with margin = Leverage × Return without margin
You may notice that this formula is very similar to one we covered in our article on the DuPont model:
ROE = ROA × Financial leverage
So leverage can help you boost your portfolio’s return, but it also increases your portfolio’s risk.
How much leverage is best?
If you are a new investor, my advice is do not use leverage (margin); this limits your risk and helps you avoid margin calls.
Once you have market experience and can generate consistent profits over several years, you can consider using leverage sensibly to boost your portfolio’s return. In my view, a reasonable level of leverage for stock trading is 1:1.5 or 1:2.
Read our detailed article on margin loans here.
Happy trading!
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