The trading community often discusses the use of leverage to increase profits. While this seems very nice, using leverage in the stock market is like using a powerful and sharp double-edged sword: It can amplify your gains as well as amplify your losses. Understanding this balance is the difference between being well into the green and going miserable broke.
What is Leverage Meaning in Stock Market?
Leverage in the stock market is a financial approach that allows an investor to control a significant position in a security using a fairly small amount of his or her own capital. To put it simply, it means you are using the broker's money to purchase an increased amount of stock.
In other words, you are taking a small amount of your own money as a security deposit (called margin) to open a much larger trade.
Important: The Leverage Ratio.
This ratio will show you your total exposure against your own capital. For example, a 2:1 leverage ratio will allow you to control Rs. 2 worth of stock for every Rs. 1 you use of your own funds, and a 5:1 leverage ratio will allow you to control Rs. 5 worth of stock for every Rs. 1 you invest.
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How Does Leverage Work?
You can utilize leverage in the stock market by primarily obtaining a Margin Trading Account.
Open Margin Account: To use leverage, you must first open a special account with your broker called a margin account.
Initial Margin: In order to open a position, you must deposit a minimum amount of your own money (often referred to as the initial margin). This money is used as collateral.
Borrowed Money: A broker will lend you the balance of what you need to purchase the total amount of the securities you purchase. You use the shares of the stock as collateral on that loan.
Enhanced Return: Your profits (or losses) will be determined based on the entire dollar amount of your position and not just what you put up as your initial margin.
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Practical Example of How Leverage Works:
Say a stock is priced at Rs. 100 per share, and you have Rs. 10,000 in your account.
As you can see, the higher the leverage, the more that profit or loss can be magnified.
How to Use Leverage in Stock Market?
For new investors, the potential for risk often trumps the potential for reward. Therefore, any beginner considering using leverage in the stock market should be extremely cautious and focus on a strict risk management approach.
1. Understand and Avoid the Margin Call
This is the single largest risk. A margin call occurs when the market value of your securities drops, and the value of equity in your margin account drops beneath the minimum maintenance requirement set by the broker.
At this point, the broker will require that you send in cash to bring your account back up to the minimum from the margin requirement.
If you don't send in cash, the broker has the right to liquidate (sell) some or all of your positions in order to protect their loan. Liquidation will often result in significant and quick losses.
2. Implement Iron-Clad Risk Management
Utilize Stop-Loss Orders: Always place a Stop-Loss order when you enter a trade. A Stop-Loss is a pre-determined exit price, which will close your position automatically if the market turns against you. This helps protect your capital from being completely wiped out by an unforeseeable price movement. Refer to our guide on Top Technical Analysis Tools for more information about trading tools.
You should start at a low level of margin/leverage: If you are new to the market, the generally accepted ratio of leverage would be 2:1 or less, and if possible, do not use any leverage initially at all.
Avoid Excessive Leverage: Do not allow your appetite for more to affect the size of your trade. Overleveraging is the number one error most new traders make, putting too much on the line for a single trade.
Watch Interest Expenses Accumulate: Remember, you are borrowing money. The broker will charge interest (known as the funding charge) on the borrowed amount, which accrues daily, impacting your profit net, or adding to your loss.
3. Education First
Leverage should only come into your trading play after you have a firm grasp on market behavior, technical analysis, and fundamental analysis.
Start your journey with the Stock Market Beginners Course for Investors and Traders.
Learn the basic concepts with Equity Market Basics.
Educate yourself on how to read price action with our post on, Read Stock Charts and Trading Patterns.
Benefits of Using Leverage Trading in Stock Market
As long as a responsible and experienced trader uses it, leverage trading has many advantages:
Capital Efficiency: Using leverage allows you to open a much larger position without tying up a lot of your own capital, allowing you to utilize those funds for more investments or deconsolidation.
Possibility of Higher Returns: The primary allure of leverage in the stock market is its potential to achieve much higher returns on your capital with a positive change in the market, as illustrated in the example above.
Access to Derivatives: Leverage is a part of instruments such as Futures and Options (Derivatives Trading), and allows you to trade contracts worth large notional amounts while paying relatively small margin amounts. To find out more about derivatives and leverage, check out our comprehensive guide, How to Start Trading in Derivatives Market, and our course, Equity Derivative NISM Series VIII course.
Conclusion
Using leverage in the stock market is a sophisticated technique intended for experienced traders to utilize capital for efficiency and to hedge investments. New traders should be aware of the increased risk of magnified losses and the anxiety of a margin call and should only use leverage after extensive practice and education. Start with a relatively conservative approach to trading, obtain the knowledge tradable through courses such as the Technical Analysis Crash Course, become familiar with risk management systems in place, and proceed cautiously before utilizing this powerful trading technique.
FAQs
Q. Is Margin Trading safe for new traders?
A. No. Margin trading significantly raises risk because of the increased losses and the possibility of a margin call. New traders should learn to trade only with their own cash first.
Q. What is the difference between Margin and Leverage?
A. Margin is the minimum amount of cash (collateral) that you must deposit to open a leveraged position. Leverage is the ratio that describes the size of the position you can control vs your margin.
Q. Can I lose more money than I have in my account with leverage?
A. Yes. In highly volatile or fast-moving markets, a margin call and subsequent liquidation may not happen fast enough to avoid losses exceeding your account equity.
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