Using leverage in a transaction in the financial markets is a practice that can be used by individual investors and sophisticated money managers. To purchase a leveraged stock, an individual investor must open a margin account with a stock broker. In a margin account, the broker, a financial professional whose job it is to assist and facilitate trades in the financial markets on behalf of investors, lends a client money. The client or investor, in turn, purchases an asset, such as common stock, with loan capital known as leverage. By purchasing leveraged stock, profits or losses will be multiplied.
Investing with leverage is a practice that is dependent on an investor's credit. If an investor has $100 US Dollars (USD) in an account but seeks to purchase $500 USD in stocks, he could not do this without a margin account. With a margin account, the investor can borrow the $400 USD needed to make this trade. If shares of the purchased stock rise, returns are bolstered.
When an investor purchases leveraged stock from a margin account, the transaction is guaranteed by the securities being purchased and cash in the account. If a leveraged trade results in a loss, the investor must deposit additional funds into the account or sell securities to generate profits. When an investor earns money on a trade, the margin account grows, which means there is more money to trade with, and credit could increase.
Trading with leverage is practiced mostly by professional money managers, including hedge funds. This is because the results of purchasing leveraged stock can be damaging if a bad trade is made and results in a loss. An investor is responsible for any money lost in a leveraged trade. One of the key responsibilities of a prime broker is to lend money to hedge fund managers for trading. The sum of money that is lent to the hedge fund manager is tied to the amount of assets held in a portfolio.
Prime brokers adhere to a ratio when lending. For instance, a 2:1 ratio would translate into twice the leverage for the amount of assets that a hedge fund manager oversees. Excessive leverage would be a ratio of 20:1, and while excessive leverage is not common, it is not unheard of in the hedge fund sector. The benefits of purchasing leveraged stock can be extensive. Investors gain access to markets, assets and contracts that they would not otherwise afford. This helps the financial markets gain liquidity, which is the frequency at which assets are traded.