Leverage allows investors to maximize their profits when their resources are limited, but it also increases risk.
In general, most investors tend to trade using the money they have in cash. If they want to buy a stock they need to have enough money in their account to pay for that stock.
One of the drawbacks of investing with cash or cash-only holdings is that your returns are limited by your financial resources. Imagine you find an investment opportunity with a 100% return. If you only have $500, the profit will be $500.
Many professional traders borrow money to invest, or execute strategies that allow them to invest more cash than they have on hand. This is known as leveraged investing or leveraged trading. This allows them to increase their purchasing power and potential returns, as well as their risk.
How does leverage work?
Leverage trading involves any type of trading in which you trade with borrowed money to increase the amount of shares that can be purchased.
Trading with leverage is not bad if you know what you are doing and understand the risks. But if that is not the case, it is extremely risky and you could potentially lose much more than you can afford.
Is it dangerous to trade with leverage?
Leverage trading can be dangerous because it amplifies your potential investment losses. In some cases, it is even possible to lose more money than you have available to invest.
Is it good to trade with leverage?
Leverage trading can be good because it allows investors with less cash to increase their purchasing power, which can increase the return on their successful investments.
Do you have to pay back leverage?
Yes. If you borrow money to invest, for example, by trading margin, you will have to pay it back to your broker. Many brokers also charge interest on margin loans, which increases the cost of investing with leverage.
Here are the different ways you can use leverage to trade stocks:
Trading on margin.
Margin refers to the money you borrow from your broker to buy a security, using other securities in your brokerage account as collateral.
For example, imagine you have €10,000 in your brokerage account and you want to invest in a company trading at €50 per share.
If you buy shares only with the cash you have, you could pay for 200 shares. If you decide to use margin, borrowing €10,000 from your broker, you could buy 400 shares. This widens the range of possible gains and losses.
If the share price rises to €60 he would make a profit of €2,000 or 20% if he invested with cash. If I used margin, I would earn €4,000. That is, 40% of the cash invested.
However, if the price dropped to €40, he would lose €2,000 with a cash investment and €4,000 if he invested using margin. Remember that he has to pay back the money he has borrowed.
In the case of the example, he would lose all the money if the stock were to fall to a price of 25 euros per share, and he would owe money if it were below that price.
There are many brokers who also charge interest on margin loans, which increases the cost of investing with leverage.
Options are another method of trading with leverage. An option contract generally involves 100 shares of the underlying stock. Buying an options contract allows you to gain control of 100 shares for much less than the cost of buying 100 shares of a company’s stock. This means that small changes in the price of the underlying stock can cause large changes in the value of the option.
For example, imagine that you think the company “CCC” is going to lose value rather than gain value. Instead of buying shares on margin, you may decide to sell call options on the stock, setting a strike price of £40.
Call options give the holder the right, but not the obligation, to buy shares from the option seller at the set price.
There are also ETFs that use leverage to try to affect their performance compared to the market.
The Risks of Leveraged Trading
One of the main risks of leveraged trading is the fact that it amplifies your potential losses, to the point where you can lose more money than you have available.
Margin risks on leverage
For example, if you use margin to double your buying power, you double all your gains and losses. That means that if a stock you buy loses more than 50% of its value, you will lose more than 100% of the cash you had available to invest.
Another risk is that your broker may initiate a margin call. If the value of your account falls below a set threshold compared to the money you have borrowed, your broker may require you to deposit additional funds. This may happen because your broker is concerned about your ability to repay your debt if your investments continue to lose value.
If you do not deposit sufficient funds to meet a margin call, your broker may forcibly sell, without notice to you, some of your securities to repay you. Your broker also decides which securities to sell and has the right to increase margin requirements at any time.
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