Types and Forms of Leveraging in Investments - dummies

By David Stevenson

Your investment portfolio in the UK may contain forms of leveraged investments. Not all forms of leverage involve spending someone else’s money; it can work in different ways. Three main forms of leverage operating exist:

  • Financial leverage: The most obvious type, this is created through borrowing leverage in your portfolio (through margin calls, see the later section ‘Buying on margin’) or at the company level (through using corporate debt).

  • Construction leverage: This is created by combining securities in a portfolio in a certain manner; that is, you may use short positions within a portfolio or hedge certain assets.

  • Instrument leverage: Virtually all options and most futures-based contracts have some form of gearing built into them; that is, you may invest in a gold option that magnifies any increase in futures prices three-fold.

One example of leverage that doesn’t involve borrowing works at the company level, through buying shares in a firm that uses leverage in its own business.

Imagine a company that’s involved in mining gold from large mechanised operations in Southern Africa. Although you can invest in a fund that tracks the price of gold, or even buy a few gold coins individually (a direct exposure to gold), investing in a gold mining company through shares via the stock market is an indirect form of exposure to gold; that is, if gold increases in value, you hope that the value of shares in the gold mine increases too.

Plus potential exists for even greater returns if gold prices rise substantially. A bump in gold prices is likely to give an exponentially huge boost to a gold producer’s top line revenue.

This example demonstrates two forms of leverage:

  • The shares are linked to the gold price and their value may shoot up if gold increases. The costs of digging gold out of the ground are fixed (the producer doesn’t have to put a whole lot of additional labour or capital into digging out increasingly valuable gold). Therefore, any extra profits from rising prices feed through into a geared increase in the profit margin.

  • Gearing (debt) on the company balance sheet works in the investor’s favour; especially if profits increase and the book value of all assets in the company starts rising.