Leverage in Trading – What it Means & Benefits

Introduction

While companies use leverage to finance assets or projects, investors use leverage to amplify their returns from stock market trades. Leverage in the stock market is synonymous with borrowing money to trade in securities. With leverage, you can trade securities worth much more than you can actually pay for. Although it sounds like a convenient arrangement, it involves a significant amount of risk, and one must trade with caution.

What does leverage mean in trading?

In the stock market, traders are always speculating on price movements and market sentiment with the aim of making profitable trades. Since derivatives entered the Indian markets, traders do not have to physically own any of the underlying assets being traded and can profit from getting the price movement direction right.

Investors who wish to trade in larger quantities of these assets also require a huge amount of capital. For many, it is a great ordeal, and here is where the stockbroker comes to their rescue. These registered stockbrokers lend investors the amount of money required to execute the trade. This borrowed amount is your leverage in the stock market, and this enables you to trade securities worth many times your actual capacity.

Since these stockbrokers take the risk of letting investors trade using their money, investors are required to deposit a small percentage of the leveraged amount with the stockbroker as a margin. The profits made by investors on leveraged trades are calculated on the total trade value and not on the deposited margin.

The total exposure compared to the deposited margin yields what is called the ‘leverage ratio.’ This ratio depends on the market that the investor trades in and his position size. This is because when the volatility or liquidity in a market is low, the likelihood of making a profit reduces. The stockbroker would then provide lesser leverage.

How does leverage in the stock market work?

Let’s understand this with an example:

Let’s say a stock is trading at ₹1,000 and you wish to buy 1,000 shares. The total capital required for this trade will be 1,000 x 1,000 = ₹10 lakh, but you only have ₹2 lakh. This means you can buy only 200 shares with your own money.

So, you take the remaining ₹8 lakh as leverage from a registered stockbroker and deposit the margin amount with him. If the margin is 20% of the trade value, you deposit the ₹2 lakh with them. By doing so you paid ₹2 lakh from your own pocket but were able to trade 1,000 shares worth ₹10 lakh (5x).

If your trade goes as expected and the stock price rises by 10% (New price = ₹1,100), your total profit will be ₹100 x 1,000 = ₹1 lakh

Without leverage in the stock market, your total profit would have been only ₹100 x 200 = ₹20,000. Hence, through a leveraged trade, you not only gained 5x exposure but also made 5x profit.

In which markets can you use leverage?

Apart from the stock market, there are various other markets that you can trade in using leverage:

1. 1.      Indices: An index tracks a group of securities belonging to a sector, market cap, etc. Since indices are not physical assets, they are traded using financial instruments that mimic their price movement (like ETFs).
2. 2.      Foreign Exchange (Forex): Various currencies can also be traded on different exchanges to take advantage of the arbitrage opportunity and make a profit. This is also the world’s largest market by trading activity.
3. 3.      Cryptocurrencies: Cryptocurrencies dabble in the unregulated space but function in a similar manner as the forex market. These can also be traded over various exchanges for arbitrage opportunities. Since the biggest cryptocurrencies like Bitcoin and Ethereum are very expensive, leverage trading comes in handy.

Benefits of Using Leverage Trading in the Stock Market

There are several benefits of using leverage to trade in the stock market:

1. Leverage helps traders gain exposure up to 4-5x of what they can afford to pay for. This arrangement makes it less financially burdensome for the trader.
2. Leverage also helps traders maximize their potential profit stemming from higher exposure to the underlying security. Even if the underlying asset’s price moves minimally, the possibility of making big gains still remains.
3. Since leveraging is available in various markets, many avenues are open for a trader. Moreover, there is complete freedom to deploy the leveraged amount in a way the trader deems fit.
4. With leverage, traders can not only gain greater exposure to an asset, but they can also trade in dearer assets that are otherwise out of reach. Premium pricing on some securities makes them impossible to trade in with small capital.

FAQs

Is leverage trading riskier than normal stock trading?

Yes, it is. Since this involves trading using borrowed money, it is significantly riskier. Traders who use leverage to make high-quantity trades also run the risk of a bad trade which can cause heavy losses due to overexposure.

What are the downsides of leverage trading?

There are downsides, just as there are upsides to using leverage in the stock market. If the loss is huge, it can even deplete your margin deposited with the stockbroker. In this case, you will get a margin call and will have to pay it additionally to the stockbroker.

Is there a way to mitigate risk in leverage trading?

Yes, there is. It is recommended that traders use a strict stop loss such that adverse price movements do not cause losses beyond a certain extent. This has proven to be effective in limiting your losses.

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