Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. The financial instruments that can be used to create leverage include options and futures, among others. For example, $1,000 invested in stocks might buy 10 shares of XYZ stock, but the same $1,000 can be invested in five options contracts, thus controlling 500 shares.
Leverage also refers to the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Companies use debt to finance their operations. This increases their leverage because it enables them to invest in business operations without increasing equity. For example, if a company formed with an investment of $5 million from investors, the company has $5 million of equity with which to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.
Leverage means greater risk, however. While leverage magnifies gains, it also magnifies losses, so that if an investment moves against the investor, the loss is much greater than if it had not been leveraged.