I recently had an acquaintance ask what leverage was, which made me realize that many of our readers without financial backgrounds may be scratching their heads.

Let's give a simple example (when I used to trade I was shocked and astounded when I first realized just how much leverage they allowed).

Let's say that you have a trade or investement that you expect will make 5%. Say you've got a $1,000 to trade with. Your normal profit would be $50. Not bad, but meh, you want more.

So, borrow more money against it - borrow $29,000. Now you have $30,000. By $30,000 worth of the stock. Your profit? $1,500.

And all the money of your own you put up was $1,000. At the end of the trade, you have $2,500 in your account. Your profit? 150%! Wow!

Sounds rocking!

But what if the instead of the security you were buying going up 5% it declines 5%? When you sell out, you owe $1,500. Too bad you only have $1,000.

So, if that's your life savings and/or capital, you're now bankrupt.

Let's take it one step further. It drops 20%. Which means you're at -$5,000. What do you do?

Well, since you don't want to go bankrupt, perhaps you don't close out the trade. Theoretically your at negative worth, but as long as no one asks for money, as long as you aren't forced to close out that trade... well, it's all good.

And that's where many of us are quite sure that a lot of brokerage houses are. They're probably insolvent. But as long as they aren't forced to sell (or "unwind") well, they can stay in operation.
But if someone says "no, we want that trade closed out now", well then, it all comes down.

Leverage is really, really dangerous, especially if you don't limit downside risk somehow. And in a lot of cases the banks and brokerages seem to have not limited their losses properly.

(I left the cost of borrowing out for simplicity. Borrowing does cost money and it will eat into your profits. So if you're earning 6% and borrowing at 1%, which was entirely possible for quite a while, then you would make less, depending on duration. )