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FINANCIAL TERMINOLOGY: GDP, Financial Leverage, Options Market
Three important financial concepts to understand for 2023
Gross domestic product, financial leverage, and options together can conquer the world of finance and make you financially independent, even in the economic crisis we are experiencing today. Join us on our 24Hour journey as we learn how to leverage our investments by understanding these three key concepts.
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GDP, the macro-performance indicator
Our first stop on our financial journey is the gross domestic product, also known as GDP. So what does it mean, and why do people care so much about it? Let's break it into simple and understandable parts.
According to Moneta Bank, one of the financial institutions in the Czech Republic, "GDP is a key macroeconomic indicator used to measure the overall performance of a country's economy." In other words, GDP shows us in which direction the country's economy has been developing for the previous year, whether negatively or positively. Usually, it is stated in percent to have a relative understanding of the economy's health and economic situation as of today.
Speaking more mathematically, GDP is the sum of all goods and services produced for a certain period in the territory of that state, as noted by Moneta Bank in its financial dictionary. For instance, every Škoda built on the territory of the Czech Republic would be part of the country's GDP.
What is the GDP equation?
From Moneta's Bank's definition of gross domestic product, it is clear that products and services (produced on its territory) are included in GDP. Yet, the question remains: what goods and services do economists count as a part of the gross domestic product?
The question takes us back to classroom Macroeconomics 101. In particular, it is the equation of the national income formula representing the GDP, y = c + i + g + (x-m). All these components represent parts of the gross domestic product, respectively: c - consumer spending, i - investment, g - government spending, x - exports, and m - imports.
Consumer spending, or personal consumption expenditures, represents the number of money people spend on goods and services. Cars, clothes, food, furniture, fuel, healthcare, and banking services are all vivid examples of this category.
Another component of the gross domestic product is investments divided into two distinctive groups, fixed assets and changes in private inventory, as noted by Kimberly Amadeo in Balance, a media outlet focusing on personal finance. It refers to new capital purchases such as real estate, inventories, and business equipment. Investment in stocks, bonds, or simply trading financial assets on the market is not included in the investment component of the gross domestic product.
Government spending accounts for the most significant part of the gross domestic product. A vivid example of government spending would be the following: social security, medical care, military equipment, road maintenance, research, and education. In a nutshell, the government spends money on three categories: equipment, infrastructure, and payroll, as Jason Fernando at Investopedia reported.
The last component of gross domestic product is net exports, also known as the difference between exports and imports. For instance, if a country exports 200,000 Kč worth of goods and imports 150,000 Kč worth of goods, its net exports are 50,000 Kč. Since it is a positive number, net exports are added to GDP.
Land, labor, capital goods, entrepreneurship
You cannot calculate GDP without having the basis of economic growth. Economic growth can be defined as "an increase in the production of goods and services, dependent on the four factors of production." If there is no proliferation of goods and services, there is no economic growth, thus no positive increase in GDP. That is why it is essential to understand which factors contribute to it.
There are four main factors of economic growth: land, labor, capital goods, and entrepreneurship, as highlighted by Ross in the Investopedia article. All these factors are connected as they are used to create a specific good or provide a service. Let's be honest: you cannot expect an iPhone or a Tesla to appear out of nowhere like dark magic.
As a vivid example of a real-life situation, let's consider the production of a Tesla vehicle while addressing all four factors of economic growth - land, labor, capital goods, and entrepreneurship. Undoubtedly, it would be best if you had a place to build a genius machine, whether real estate, a factory, or simply land, our first contributor to growth.
What comes next? Well, you could only put Tesla together with people. Even though some processes can be automated nowadays with the help of conveyors, robots, and other things, some activities have to pass a sanity check from the people responsible for assembling.
While you have a labor force to work at the factory, the next step in your production chain is capital goods such as equipment, machinery, and robotics. Automation is a crucial element of progress, so help your workers install some conveyors and welcome robots to your new workplace.
The most valuable and essential part of building a Tesla is entrepreneurship, with the help of which people turn their dreams into business ideas. According to Investopedia, in most cases, entrepreneurship reflects the visionaries and innovations of the people behind the production process.
As you can see, we need all four factors of economic growth to assemble one Tesla. And by building a car (creating a specific good), Tesla contributes to the country's gross domestic product.
The ugly sibling to economic growth
While economic growth is the state everyone strives for, we should remember that some factors could stop it. This is known as "economic contraction," a decline in economic growth.
There are a couple of reasons why economic contractions appear from time to time in the economy. Loss of consumer confidence, high-interest rates, stock market crashes, and bubble bursts are a few examples of the underlying roots of the problem. Economic contraction can lead not only to the slowdown of economic growth and a decrease in GDP but also to something more serious: a recession.
The mechanism of economic contraction is pretty straightforward. "It is caused by a loss of confidence that slows demand. An event, like a stock market correction or crash, triggers it. But the true cause precedes the well-publicized event. Investors sell stocks, sending prices down and reducing financing for large corporations. Businesses cut spending, then lay off workers," explained Amadeo for the Balance. One of the most recent examples of economic contraction was the coronavirus pandemic and energy crisis. Both events slowed economic growth and development.
In most cases, economic contraction ends when prices fall enough to attract renewed demand to the market, said Amadeo.
Economic downturn and financial leverage: a romantic relationship??
An economic downturn does not have to be the end of the world. Instead, you can see it as a possibility to leverage the next investment. Moneta Bank defines financial leverage as a way of investing in the world of finance that an investor uses to buy assets.
Financial leverage "can boost economic growth by allowing firms to invest in machinery to expand their scale of production, or by allowing people to purchase homes and cars or invest in education," stated Barajas and Natalucci in the IMF Blog, an online media outlet for the international monetary fund. Other examples of financial leverage include taking out a mortgage to buy a home, taking out student loans, borrowing money to start a business, and tapping borrowed funds to invest in the stock market.
While financial leverage has many benefits, such as starting an investing journey, growing your wealth over the long term, and improving your lifestyle and quality of life, challenges are afoot. For instance, only some investments are guaranteed; borrowing money could be risky, and you could lose everything.
So, what's the best option to utilize financial leverage?
Options: the pre-agreed price at a pre-agreed time
Options can provide relative financial leverage, and their risk is only suitable for some investors. What is an option, and why might you consider utilizing it during an economic downturn?
"An option is a financial instrument that allows you to buy or sell assets at a pre-agreed price at a pre-agreed time. This right can be exercised on shares, commodities, and currency pairs," explained Moneta Bank. So, if you can see the future of the particular stocks rising above a certain amount, the option is a win-win game for you.
However, there might be a sequence of events when stock behavior is not predictable, and instead of rising in price, it goes downhill. "If the underlying stock price does not rise or fall as anticipated during the option's lifetime, leverage could magnify the percentage loss," stated Merrill, a Bank of America company. That is why it is essential to understand all the potential risks you may face when buying an option and challenging the market.
Still trying to decide whether options are the best way to start your investing journey today? In that case, we invite you to join our Shadow Trading Program at 24Hour Investing, where you can learn how to trade by following professional traders. Build your financial portfolio, improve your quality of life, and perform this even during challenging times of the energy crisis.