Leverage trading is any type of trading that involves borrowing money or increasing the number of shares involved in trading by the number of shares you can afford to pay for in cash.
How Does Leverage Trading Work?
Leverage trading, in its simplest sense, is any type of trading that involves borrowing money or increasing the number of shares involved in trading by the number of shares you can afford to pay for in cash.
It is not bad to trade on margin if you know what you’re doing and understand the risks. However, if you don’t, it can be extremely risky, and you can lose more than you can afford.
Here are different ways you can use leverage in stock trading:
Margin Trading
A simple example is margin trading. Margin is the money you borrow from your broker to purchase a security, using other securities in your brokerage account as collateral.
Note: Federal regulations set a minimum margin requirement of 50%, meaning you can borrow up to 50% of the price of the security you wish to buy. Some brokers may have higher requirements.
For example, you have $10,000 in your brokerage account and want to invest in XYZ Company. XYZ stock is currently trading at $50 per share.
If you buy stock with just the cash you have, you can buy 200 shares. If you decide to use margin and borrow $10,000 from your broker, you can buy 400 shares instead. This increases the potential profits and losses.
If the stock price rises to $60, you will make a profit of $2,000 or 20% if you invested with cash. If you used margin, you will make a profit of $4,000 or 40% on the money you invested.
However, if the price drops to $40, you will lose $2,000 if you invested with cash and $4,000 if you invested using margin. Remember: you have to pay back the money you borrowed from your broker.
You would lose all the money you invested if you used margin and the price of XYZ stock dropped to $25. You would still owe money to the broker even after selling your shares if the price fell below $25.
Note: Many brokers also charge interest on margin loans, increasing the cost of leverage investing.
Derivatives Trading
Options are another way to trade with leverage. One options contract typically involves 100 shares of the underlying security. Buying an options contract allows you to control 100 shares at a cost much lower than buying 100 shares of the company. This means that small changes in the price of the underlying security can cause large changes in the value of the option.
Imagine you believe XYZ will lose value instead of gaining value. Instead of buying the stocks using margin, you might decide to sell call options on the stock, specifying a strike price of $40. Call options give the holder the right to buy the shares from the options seller at the specified price.
If XYZ remains above $40, it is likely that the option holder will exercise the option, forcing you to buy the shares on the open market to sell those shares to them at $40 per share. One contract covers 100 shares, meaning if XYZ is trading at $41 at the time of exercise, you will lose $100. If it is trading at $50, you will lose $1,000.
Leveraged ETFs
There are also leveraged ETFs that use leverage to try to amplify their performance compared to the market.
Note: ETFs typically track a specific index; leveraged ETFs aim to track the gains or losses of the index they are compared to. For example, the Direxion Daily S&P 500 Bull 3X Shares ETF (SPXL) aims to achieve 3 times or 300% the daily returns of the S&P 500.
There are
inverse ETFs aim to achieve performance that is opposite to that of the benchmark index. A 3x inverse ETF aims to triple the performance of the underlying benchmark index. So, if the underlying benchmark index is negative, a 3x inverse ETF like ProShares UltraShort (QQQ) ETF will return a positive gain of 3 times.
Risks Associated with Leveraged Trading
One of the main risks of leveraged trading is that it amplifies your potential losses, which can lead to losing more money than you have.
Margin Risks and Margin Calls
For example, if you use margin to double your buying power, you double all your profits and losses. This means that if the stocks you buy lose more than 50% of their value, you will lose more than 100% of the money you had available for investment.
Another risk is that your broker may begin a margin call. If the value of your account drops below a certain threshold compared to the money you borrowed, your broker may require you to deposit additional funds. This happens because your broker is concerned about your ability to repay your debts if your investments continue to lose value.
Note: If you fail to deposit enough money to meet a margin call, your broker may sell some of your securities to cover themselves, sometimes without notice. Your broker also decides which securities to sell and has the right to increase margin requirements at any time.
Unlimited Loss Risk with Options
Some leveraged trading strategies, particularly options, carry unlimited risk.
If you sell a call option and the option writer exercises it, you will need to buy 100 shares of the stock to sell to the option holder. If the strike price is $50 and the market price of the stock is $60, you’ll lose $1,000. If the market price is $70, you’ll lose $2,000. If the market price of the stock is $1,000, you’ll lose $95,000.
The higher the stock price in the market, the greater your loss. Because theoretically, there is no limit to how high a stock price can go, there is no cap on how much money you can lose. Imagine every share trading at $1 million or $10 million. You would lose hundreds of millions or even billions of dollars.
Although this scenario is unlikely, it is important to understand that the risk associated with this type of options can be enormous.
Leveraged ETFs Are Not for the Long Term
Even buying shares in leveraged ETFs carries risks. Most funds “rebalance” daily, meaning they only aim to match the performance of the underlying index for one day. Over the long term, returns from these funds can diverge significantly from the overall returns of the index.
For instance, according to the SEC, between December 1, 2008, and April 30, 2009, an index rose by 8%. At the same time, a 3x ETF that tracks the index fell by 53%, while a 3x inverse ETF that tracks the index fell by 90%.
Key Takeaways
Leveraged trading involves borrowing money to invest in the stock market. Leverage increases the risk of loss, which could lead to unlimited losses in the event of poor investments. Your broker may sell investments on your behalf if their values drop below a specified amount.
Frequently Asked Questions (FAQs)
Is leveraged trading risky?
Leveraged trading can be risky because it increases potential investment losses. In some cases, you may lose more money than you have available for investment.
Is
Is trading with leverage good?
Trading with leverage can be good because it allows investors with limited financial liquidity to increase their purchasing power, which can enhance the returns on their successful investments.
Do you have to pay back the leverage?
Yes. If you borrowed money to invest, such as trading on margin, you will need to repay it to your broker. Many brokers also charge interest on margin loans, which increases the cost of leveraged investing.
Source: https://www.thebalancemoney.com/trading-using-leverage-1031047
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