The majority of regular investors use their funds to trade stocks and other assets. If they wish to buy a stock, they must have sufficient funds in their account to cover the cost of the shares. One disadvantage of investing only with cash is that your profits are constrained by your financial means. If you …
The majority of regular investors use their funds to trade stocks and other assets. If they wish to buy a stock, they must have sufficient funds in their account to cover the cost of the shares.
One disadvantage of investing only with cash is that your profits are constrained by your financial means. If you only have $500 to invest, even if you uncover an excellent investment opportunity that returns 100%, you will only make a $500 profit.
Many skilled traders take out loans to invest or use techniques that allow them to invest more money than they have. This is referred to as leveraged investment or leverage trading.
This allows individuals to significantly enhance their purchasing power, prospective rewards, and risk.
What Is Leverage Trading & How Does It Work?
In its most basic form, leverage trading is any sort of trading that includes borrowing money or otherwise raising the number of shares included in a deal beyond what you could afford if you paid cash.
Leverage trading isn’t always a negative thing if you know what you’re doing and are aware of the consequences. If that isn’t the case, it’s highly risky, and you might lose a lot more money than you can afford.
The following are the various methods you may use leverage to trade stocks:
Margin Trading
Margin trading is a basic explanation. Margin is money collected from a broker to buy an asset using the collateral of other securities in your brokerage account.
For instance, suppose you have $10,000 in your brokerage account and wish to invest in XYZ Company. Currently, XYZ is trading at $50 per share.
You could buy 200 shares with just the cash you have on hand. You may buy 400 shares instead if you opt to use margin and borrow $10,000 from your broker. This increases the size of your prospective gains and losses.
If the stock price climbs to $60, you’ll make a $2,000 profit, or 20%, if you invest with cash. If you used margin, you’d make $4,000, or 40% of the money you put in.
If the market fell to $40, you’d lose $2,000 with a capital outlay and $4,000 with a margin investment. Keep in mind that you must repay the money you borrowed from your brokerage.
If you utilised margin and XYZ’s stock value fell to $25, you’d lose all you invested. If the price of your shares went below $25, you’d owe that money to the broker even after selling them.
Trading Derivatives
Another way to trade with leverage is to use options. 100 shares of the underlying securities are generally involved in a single options contract. Purchasing an options contract allows you to control 100 shares for a fraction of the price of purchasing 100 shares of a firm. This implies that modest changes in the underlying security’s price can result in huge changes in the option’s value.
Assume you believe XYZ will depreciate rather than appreciate. You may sell call options on the stock with a strike price of $40 instead of buying shares on leverage. The holder of a call option has the right, but not the duty, to purchase shares from the option seller at a predetermined price.
If XYZ’s price continues above $40, the option holder will almost certainly exercise the option, requiring you to acquire shares on the open market and offer them to them for $40 each. One agreement covers 100 shares, so if XYZ is trading at $41 when you execute the option, you will lose $100. You’ll lose $1,000 if it’s $50.
Leveraged ETFs
Some exchange-traded funds (ETFs) utilise leverage to try to influence how they perform in comparison to the market.
Inverse exchange-traded funds (ETFs) seek to produce the opposite of the benchmark index’s outcome. A 3x inverse ETF seeks to triple the underlying index’s negative outcome. As a result, if the underlying index is negative, the 3x inverse ETF, such as ProShares UltraShort (QQQ), will yield a positive 3x return.
The Risks With Leverage Trading
One of the most significant disadvantages of leverage trading is that it magnifies your potential losses, perhaps to the level where you lose more income than you have.
Margin Risks & Margin Call
If you utilise margin to double your buying power, all of your gains and losses are multiplied twice. That means that if a stock you hold loses and over 50% of its value, you will lose all of the money you have set aside to invest.
Another possibility is that your broker will issue a margin call. If the value of your account falls below a certain level as compared to the amount borrowed, your broker may require you to deposit extra funds. This might occur if your broker is concerned about your capacity to repay your loan if your holdings continue to depreciate.
Potential For Unlimited Loss With Options
Some leverage trading methods, especially options, have an unlimited risk potential.
If you offer a call option and the option seller executes it, you must purchase 100 shares of stock to sell to the call holder. You’ll lose $1,000 if the market rate is $50 and the stock’s market value is $60. You will lose $2,000 if the market value is $70. You will lose $95,000 if the market value of a share is $1,000.
The larger your losses, the higher the market value of the stock climbs. Because the price of a share might potentially grow indefinitely, there is no limit to how much money you can lose. Assume each share is worth a million dollars or ten dollars.
Hundreds of millions or billions of dollars would be lost.
While this is unlikely because there is no limitation to how high a stock may go, it’s vital to note that the risk associated with these types of options can be enormous.
Leveraged ETFs Not For The Long Haul
Investing in leveraged ETFs has its own set of risks. Most funds “reset” daily, which means they simply try to replicate the index’s one-day performance. Their returns can vary considerably from the benchmark’s total returns over time.
According to the SEC, an index increased by 8% between December 1, 2008, and April 30, 2009. In the meantime, a 3x leveraged ETF following the index dropped 53%, while a 3x inverse ETF monitoring the index dropped 90%.
