Investors use leverage to increase their market exposure by allowing them to pay less than the entire amount of the investment. As a result, utilizing leverage in a stock trade allows you to take on a larger position in a stock without paying the full purchase price.
Leverage is a double-edged sword in trading. On the one hand, it helps to magnify returns on your investment, and on the other, it can result in tremendous losses if not handled carefully.
There are two ways to utilize leverage: monetary and paper. The term “paper” comes from the fact that you’re borrowing money rather than purchasing something with it. When you use this method of leveraging, it’s called leveraged trading. A trade is said to be “leveraged” when a trader borrows a proportion of the funds required for an investment to profit from them more significantly or faster than they would on their own.
An example of how leverage works:
If you want to purchase $10,000 worth of stock XYZ with a 0% margin loan, all you need to provide is $1,000 as a down payment. The remaining amount ($9,000) will be borrowed from your broker at low-interest rates (3%). In this case, purchasing shares with a 0% margin loan allows you to control 100 shares instead of only ten shares that are available when operating with a cash balance ($1 per share). At the end of the day, the market price of XYZ is $11, so you can sell all your shares for a total of $1,100.
Since the margin loan only costs 3%, your net profit will be $900 (i.e. the difference between sale and purchase price) minus interest charges or $90. Your return on investment or ROI (%) would be 900/1000 = 90%.
If the price of XYZ stock had dropped to $8 instead, by selling your ten shares, you would generate a loss of 10*($8-$10) = -$80. However, since you had borrowed money from the broker at an interest rate of 3% per annum, borrowing costs would amount to 30 cents (3% * 100 =0.30) for the ten shares, resulting in a loss of -$80-0.30 = -$80.70 (or Rs 46).
The cost of borrowing, however, is less than the total amount of your losses on this transaction, and as such, your ROI would still be 990/1000 = 99%!
Suppose you had not borrowed money from the broker to magnify your returns using leverage but instead used all of your funds. In that case, your gains or losses will be proportional to those shown above: i.e., if XYZ stock fell by $1 per share, you would lose 1*($10-$11) = $9 per share on 100 shares versus losing 10*($8-$10) = -$80 if you had only controlled ten shares without any leverage.
In a nutshell, borrowing money from a broker magnifies both gains and losses in trading, so it is imperative to understand what you are doing when using leverage. This is why I generally recommend that traders start with low margin or even 0% margin loans before gradually increasing their equity. They become more comfortable with the entire process of buying and selling shares at various prices. Some brokers provide demo accounts where you can practice your trading skills risk-free for several months before risking real money!
If at any point in time during this learning period you feel uncomfortable with the amount of risk involved, stop trading and don’t do it anymore! But keep in mind that over time, the company you work for may provide stock options as incentives to reward your performance at work. Since these come with built-in leverage of typically 1:1 or 2:1, consider yourself lucky because this is where many people start their trading careers!
We hope you enjoyed this article on leverage and how it works! To gain more experience leveraging your investments, try out a demo account or view the different stock options available through your company.