Leverage
Leverage allows financial market participants to increase potential returns, but leverage also increases risk.
Explicit Leverage
The simplest way to obtain leverage is to borrow money. If a hedge fund has $100 million of capital, and borrows $200 million, then the hedge fund can buy $300 million worth of securities. We would say that the hedge fund is 3 times, or 3x, leveraged,
[$300 million of exposure] / [$100 million of capital] = [3x leverage]
We often refer to this type of leverage, which relies on borrowing, as explicit leverage.
Implicit Leverage
Some financial instruments have built-in or implicit leverage. For example, for the same amount of money invested, compared to the underlying instrument, options typically provide the potential for both greater gains and losses. We can measure this implicit leverage by comparing the delta exposure of an option to its market value. If the delta exposure of an option is $40, but the market value is only $10, we would say the option provides 4x leverage,
[$40 delta exposure] / [$10 market value] =[4x leverage]
In other words, even though the option should only cost $10, we are getting the equivalent of $40 of exposure to the underlying, or 4 times the exposure.