Leverage means using borrowed money to make bigger bets. Instead of investing only your own $100,000, you borrow $400,000 and invest $500,000. If the investment goes up 20%, you make $100,000 on a $100,000 investment — a 100% return. Without leverage, the same 20% gain earns only $20,000.
But leverage cuts both ways. If that $500,000 investment drops 20%, you lose $100,000 — your entire original capital. And you still owe the $400,000 you borrowed plus interest. This is why leverage is called a double-edged sword — it amplifies both gains and losses.
The leverage ratio measures how much debt relative to equity. A 2:1 leverage ratio means $2 of debt for every $1 of equity. Lehman Brothers had a leverage ratio of 31:1 when it collapsed in 2008 — a tiny 3% drop in asset values wiped out all equity. Regulators now impose strict leverage limits on banks (Basel III requires minimum capital ratios).