Leverage: Multiplying the gain, and the ruin

Leverage means investing with borrowed money. It multiplies everything: gains, and losses.

Say ten thousand euros of your own. You borrow forty thousand more. Now you have fifty thousand euros invested.

That is leverage of five. Every market move counts five times for your money.

The market rises ten per cent: five thousand euros of gain. Fifty per cent on your stake.

The market falls ten per cent: five thousand euros of loss. Half your money is gone.

The market falls twenty per cent: ten thousand euros of loss. You have nothing left. The market has only lost a fifth.

And that is not all. After a ten per cent fall, you have five thousand euros left, for forty-five thousand invested.

Your leverage has gone from five to nine. The more you lose, the bigger the leverage. That is the trap.

The lender knows it. When your stake melts, it calls you. That is the margin call.

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Two choices. Put money in right away. Or let it sell your securities, at the worst moment, to repay itself.

At that point, you are no longer the one deciding. Leverage takes over.

In nineteen ninety-four, an American fund was born: LTCM. Among its partners, Myron Scholes and Robert Merton.

Both received the Nobel prize in economics in nineteen ninety-seven. The fund had the best brains in the world.

Its method: spot tiny price gaps, and blow them up with enormous leverage. About twenty-five times its capital.

In August nineteen ninety-eight, Russia defaulted on its debt. The gaps, instead of closing, opened everywhere.

Within a few weeks, the fund lost most of its capital. And it owed money to almost every major bank.

In September, the New York Federal Reserve brought together fourteen banks. They put in three point six billion dollars to prevent contagion.

Twenty-three years later, Archegos. A firm managing the fortune of a single man, Bill Hwang.

He bought shares with money from several banks, through contracts that hid his size. None saw the total.

In late March two thousand twenty-one, some of his shares fell. Margin calls came. The banks sold, all at the same time.

In two days, about twenty billion dollars vanished, according to the press. Credit Suisse alone lost more than five billion.

Two stories, one lesson. Without leverage, you can wait out a fall. With leverage, you can be forced to sell at the bottom.

Leverage also hides elsewhere: buying on credit, some products or contracts online. Always look for the multiplier.

And ask one question above all: what fall takes me to zero? With leverage of five, twenty per cent is enough.