I have often pondered about leverage. Not personal leverage kind of stuff. No, I’m talking about mathematical leverage. Let me give you a couple of simple examples of leverage.
First example: options. Let’s say you buy a Tesla call contract at a strike price of $1,000 at a certain expiration date. One call contract allows you to buy 100 shares of the underlying stock at the strike price at the expiration date. So, if the market believes that TSLA is going to be priced at $1,100 at that date, your contract is worth $100×100 = $10,000. What if TSLA ends up 10% higher, at $1,210 per share? Your contract is then worth $21,000, or 110% higher! Let me repeat for impact, a 10% increase in the stock price results in a 110% increase in the value of the option. Options allow the trader to make outsized returns on a relatively small investment. This, dear reader, is the force of the mathematical leverage.
Second example, still in finance, but probably more relatable to most. House purchase. Let’s say you buy a house valued at $500k, with a 20% down payment of $100k, so you owe $400k in mortgage. So your initial investment is $100k. In 10 years, your house appreciates by 50%, so it’s now worth $750k. For illustrative purposes, let’s assume the money you’ve paid towards the principal of the mortgage balances out the transaction costs of buying and selling the house. So you still owe $400k. You sell the house for $750k, pay the bank $400k, and pocket $350k. So in 10 years, you’ve made $250k profit on the initial $100k investment. A 250% return in 10 years is pretty solid, isn’t it? Force of leverage.
Third example: salary. I live in LA, and let’s say maintaining the average standard of living while also paying prior debt and saving costs $30k/year. And to simplify, let’s say salary is taxed at a flat rate of 25%. A base salary of 60k becomes $45k/year after tax. So you have $15k disposable income after subtracting $30k cost of living. What if you get a new job that pays 10% more? Base salary of 66k becomes $49.5k after tax, giving you $19.5k disposable income, or 30% more! Let this sink in for a second. A seemingly small change in salary of 10% actually makes you 30% wealthier. So, don’t hesitate to ask for even a small raise or a slightly larger bonus. Because of the leverage, the little bump in compensation can lead to a much larger bump in wealth!
And for one more example, let’s tie this concept to pricing. A friend of mine sells servers. Let’s say a server costs $900 to make. If he sells the server for $1k, he makes $100. If he is a phenomenal seller and sells the server for a mere 5% more, at $1,050 a piece, he makes $150 each server, an increase of 50% in margin! The implication here is that you should always try to increase the price of the product or service you provide, even just for a small amount, because the slightly increased price may result in a significantly increased profit!
The force of leverage is a powerful tool in business and a powerful rule in life. I challenge you to find other examples of mathematical leverage you see in everyday life. 😉
Richard Anderson 