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In the stock market, financial leverage unfolds a deck of risk and reward. Financial leverage means utilising external capital to boost potential profits rather than what could be gained using only one’s own capital.
Alluring to most market participants, leverage trading is an intriguing concept that has the potential to turn modest investments into substantial positions. However, this potential of magnifying gains is accompanied by the risk of amplified losses.
This exploration seeks to offer a thorough understanding of leverage to help our readers get familiar with leverage mechanisms’ intricacies.
What is leverage in the stock market?
Leverage in the stock market refers to the ratio by which a trading position is magnified more than the capital you put up as a margin. In another way, the leverage ratio is the measure of a trader’s total market exposure against a margin.
Margin is a percentage of the total trade amount required to take a position in the market.
For example, the leverage is 10:1. This ratio shows that you employ one-tenth of the actual trade amount as a margin. So, if you want to trade Rs. 1 lakh, you need to pay only Rs. 10,000 in margin.
Leverage is used across financial markets to trade varied securities, including stocks, commodities, forex, exchange-traded funds (ETFs), etc., subject to rules and regulations in India.
Exploring leverage trading
Leverage trading refers to an act of taking positions in financial markets using borrowed funds. It is an effective strategy to control a larger position using a small portion of your capital. There are several ways to utilise leverage trading in financial markets.
- Margin trading
Margin trading involves borrowing funds from a stockbroker at an interest rate to increase the exposure with a trading position.
For example, if a trader offers 3:1 leverage, you can initiate a trade of Rs. 30,000 with a capital of just Rs. 10,000 from your own money and Rs. 20,000 borrowed from the broker.
- Options trading
Another way is options trading, where traders use financial derivatives – options contracts – to trade using leverage. Options are a privilege for traders as they grant the right, but not the obligation, to buy or sell an underlying security at a preset price on or before it expires.
While leverage trading amplifies the potential returns of investments, it carries an increased risk of potential losses. Therefore, understanding the associated risks with leverage trading is paramount.
Significance of leverage for traders
- Access more investment opportunities: With leverage, traders can partake in more substantial trades or allocate capital to multiple trade positions.
- Significant gains in successful trades: Individuals utilising leverage trades can gain substantially when trades go well in the anticipated direction.
- Grabbing short-term opportunities: Sometimes, market fluctuations offer short-term trading opportunities that traders need to grab quickly.
- Defying price tag limitations: Leverage disrupts the scenario of hefty prices and allows you to trade desired securities with a high potential for profits.
Understanding the risks and challenges of leverage trading
- Margin calls: When the value of a margin trader’s margin account falls below the required margin, brokers can make margin calls. You need to fund the account to avoid liquidating assets at low prices, potentially increasing the margin trade losses.
- Market fluctuations or downturns: Leverage can erode the invested capital in no time as it amplifies losses, especially if strategies do not back margin trades.
- Interest and fees associated with leverage: There can be other fees levied on margin trades, which can add to the overall cost of leverage trading.
- Excessive use of leverage: When the leverage ratio does not align with an individual’s risk profile and availability of funds to meet losses, it heightens the risk involved in leverage trading.
Best practices while engaging in leverage trading
- Understanding the comfort zone in leverage trading is essential so that traders do not compromise on their financial status.
- Start with small leveraged positions to understand how it impacts their trades without exposing their funds to high risk.
- Ensure to utilise stop loss to safeguard your trades.
- Analyse your time horizons. Short-term gains and long-term gains have different approaches and products.
- Research-based diversification to understand the history, trends and potential returns of leveraged products.
The allure of leverage lies in the prospect of amplifying gains, but it can also amplify losses within the blink of an eye. Exposing to appropriate positions in the stock market, practising diversification, and having a clear risk profile are vital for prudent risk management while considering leverage.
There is no fixed number that suggests how much leverage is safe. It depends on the investor’s capacity to absorb risks in case of losses. For novice and frugal investors, a lower leverage like 5:1 or 10:1 may be suitable.
No, leverage trading is not risk-free. Risk-free strategies are seldom available in the stock market. If prices do not go as expected, a leveraged trader not only loses money on the stock but will also lose money while paying interest to the broker. So, the loss in leverage trading is unlimited.
Yes, leverage trading can help in magnifying profits. Leverage trading allows traders to take bigger positions. So, they can earn higher profits, provided the asset’s price moves as expected.
Leverage in intraday refers to entering intraday trades on a margin. It is where traders give brokers an initial deposit and take loans on it to enter high-value transactions. These margins give investors more capital than they currently own, facilitating them to enter large trades.
20X is a ratio showing the percentage of leverage. 20X indicates that traders can get a margin that is 20 times more than their initial deposit. So, if a trader deposits ₹1,000, the margin amount will be ₹20,000.