The ability to handle or manage a significant sum by spending only a tiny part of your own money and borrowing the rest is referred to as leverage. It is financially referred to as ” OPM (Other People’s Money).”
When an investor borrows money to buy a stock, this is an example of leverage at work. Assume the stock price of Company ’’ ABC ‘’ is $100 and you have $10,000 without leverage; the maximum number of shares you can purchase is 100. If the company’s stock price climbs to $200 and you decide to sell, your maximum profit will be $10,000.
You can now purchase 200 shares if you go to a bank and borrow an extra $10,000 and use it to buy the stock. Due to high leverage stock trading, your profit will be $40,000 if the stock prices doubles. Your profit will be $20,000 once you return the borrowed money to the bank, minus the bank’s interest.
When high leverage stock trading is used correctly, it may be highly beneficial to traders and investors. When it fails, the losses can be greater than the investor’s initial investment, resulting in negative balances. If the stock dropped to zero in the case above, the investor would first suffer a $10,000 personal loss. They’d need an additional $10,000 to repay the bank.
You cannot separate the concept of leverage from that of margin in stock trading. Margin is the amount of money that a trader requires to be able to utilize leverage. The brokers demand a good faith deposit before they may issue loans to the trader. The percentage margin is shown. When the broker needs a margin of 2%, you have a leverage of 1:5 and leverage of 400:1 if they require a margin of 0,25%.
For example: Your brokerage account has $10,000, and you wish to invest in the company Abc. Abc is trading at 50 dollars per share.
You could afford 200 shares if you bought shares with only the cash you got. You can buy 400 shares instead if you wish to borrow $10,000 from your broker. This increases your possible earnings and losses.
You would make $2,000 or 20 % if you invested with cash when the share price increases to $60. You would gain $4,000 or 40% of the capital you invested if you used margin.
If the price fell to $40, though, with a cash deposit of $2,000 and a margin of $4,000, you would lose that. Remember: You must pay back your broker for the money you borrow.
If you used the margin and the Abc stock price dropped to $25, you would lose all your invested money. You would owe the broker money if the price dropped below $25 even after selling your shares.
When you have $1,000 in your account and have a 1:5 leverage ratio, then you can buy a $5,000 asset. When you have 100:1, you can purchase $100,000 worth of assets. Regulatory guidelines determine the level of leverage provided by brokers. The norms in the UK limit this leverage to 30:1. The United States requires brokers to offer leverage only to accounts having a minimum balance of $2,000.
Leverage can be beneficial in three ways. First, it can assist a trader in making revenue per trade. Secondly, a leveraged trader can trade in expensive assets such as bitcoin, gold and platinum. Without leverage, a trader with a $1,000 account could not trade gold, which is now priced over $1,200.
The amount of leverage a trader employs is critical to their profitability. When transactions go well, a trader with high leverage can make more money than a trader with lower leverage.
For example, The Swiss National Bank startled the market by pulling the Swiss Franc from the Euro in January 2015. This caused massive market swings, resulting in the near-collapse of some highly leveraged corporations. Many traders who were short the Swiss Franc and did not use stop losses lost their whole trading account in seconds.
To minimise the risk, brokers are expected to decrease the leverage ratios. Certain occurrences take place during significant elections, referendums and major releases of economic statistics.
Leverage is a sword with two edges. If all goes smoothly, high leverage stock trading produces extra profit. Often losses exceed the total account equity if they move in the other way. The secret is to find a proper mix of leverages, as all traders make mistakes. For new traders, they should first understand the definition of leverage and margin. Then, They should trade the minimum leverage available. If they learn more, they can expand their leverage to a level where they don’t face many risks.