Leverage in Stock Market

The prospect of making high returns by investing in the various stocks of successful businesses attracts people to the stock market. So in the initial stages, an investor would like to discover good stocks. They would learn about the different investing styles, options, and factors that affect the stock price. During this process, they often encounter different terminologies and jargon that could come off as very perplexing at first. However, to become a successful investor, it is necessary to understand every jargon the stock market has to offer. This article will expand on what is the meaning of leverage in the stock market. 

The term leverage is not unique only to the stock markets. It is very likely that almost every grown-up may take some leverage at least once in their lifetime. Leverage, in simple terms, is using borrowed money to invest. In the form of a loan, most people borrow money from the bank to buy a house. This loan is nothing but leverage. Similarly, student loans are another type of leverage popularly used to help achieve one’s educational goals. Businesses use leverage to undergo expansion of their operations or purchase inventory or operational assets. 

Leverage Meaning in Stock Market

Leverage in the stock market is the borrowed capital that investors use to increase the potential return of an investment. An investor may borrow money from their stockbroker, bank, financial organization, or friend, and they are in debt to that organization or individual. 

However, leverage in the stock market gives an investor more purchasing power. The investor now has more capital with them and can invest in a larger quantity of financial assets like stocks. This can help an investor multiply their potential returns. However, an investment can also pan out against the investors. In this case, the leverage will also multiply the investors’ losses. However, the investor will have to repay their debt in both scenarios. 

How to Use Leverage in the Stock Market?

In the stock market, using leverage can be a great technique to boost your gains, but it also involves higher risk. Learn how to use leverage in the stock market by analyzing the table below.

Margin Trading: Margin trading entails taking out a loan from a broker to purchase shares. Traders must maintain a minimum margin, and the broker will lend them the remaining amount. Through the use of leverage, the borrowed funds enable investors to take a greater position than their initial capital would allow.

Leveraged ETFs: Leveraged Exchange Traded Funds (ETFs) use derivatives and debt to amplify the returns of an underlying index. For example, a 2x leveraged ETF aims to provide double the daily return of its benchmark index. However, this amplification is usually limited to a short-term period (daily) and may not reflect double the long-term returns due to the compounding effect.

Futures and Options: Trading futures and options contracts allows investors to control a large position with a small upfront payment. In the case of futures, traders agree to buy or sell an asset at a predetermined price in the future, while options provide the right (but not the obligation) to buy or sell an asset at a specific price on or before the expiration date.

CFDs (Contract for Difference): CFDs are financial derivatives that allow traders to speculate on price movements without owning the underlying asset. It enables traders to enter large positions with a relatively small initial investment. However, traders should be cautious as CFDs carry a high level of risk, and losses.

 Margin Lending: Some brokerage platforms allow investors to borrow funds from other users or institutions and use their existing securities as collateral. This peer-to-peer lending mechanism provides additional leverage for traders who seek higher exposure to the market without liquidating their current holdings.

Using leverage in the stock market can magnify both gains and losses. It’s crucial to have a sound understanding of the risks involved and use leverage prudently to avoid financial losses

Benefits of Using Leverage Trading in the Stock Market

Potential for Higher Returns: Leverage allows traders to control larger positions with a smaller amount of capital. As a result, even a small price movement can lead to significant returns. However, higher returns also come with increased risk.

Diversification: With leverage, traders can diversify their portfolios more efficiently by allocating funds to multiple positions. This enables them to spread risk across various assets and industries.

Magnified Profits: When stock prices move in the trader’s favor, leverage amplifies the profits. The gains achieved can be higher compared to trading without leverage.

Short Selling Opportunities: Leverage allows traders to engage in short selling, where they can profit from a decline in stock prices. This provides opportunities for gains in both rising and falling markets.

Access to Larger Positions: Leverage enables traders with limited capital to access larger positions, opening doors to markets and securities they might not afford otherwise.

Leveraged ETFs and Derivatives: Leveraged ETFs and derivatives offer additional leverage options to traders, allowing them to capitalize on market movements with enhanced exposure.

While leverage offers enticing advantages, it’s essential to remember that it also amplifies potential losses. It is crucial for traders to exercise caution, and implement risk management strategies, and a trading plan before utilizing leverage in the stock market. 

Margin vs Leverage

Stockbrokers offer investors the option to buy on margin, a special type of leverage. The stockbroker lends money to an investor at a fixed interest rate. The investor offers the stocks they purchase using the leverage or those in their margin account as collateral in exchange. This collateral in the form of stocks or other securities in the investors’ accounts is the maintenance margin. Whereas the investor’s amount to buy the stocks comprises the initial margin. In other words, leverage is the total sum of borrowed money that enables investors to obtain more purchasing power to invest in the stock market. While the margin is a means through which investors can get more leverage from their stockbroker.

An investor has to open a margin account with their stockbroker to buy on margin. Not every stockbroker offers a margin trading facility. So if the investor intends on using margin to trade, they should ensure that the stockbroker offers the margin trading feature. They would also require a separate margin account, so start trading using margin. The pledged stocks get held in a margin account. On the other hand, an investor can get leverage from other sources besides their stockbroker as well. Neither does an investor have to compulsorily buy on margin and pledge their stocks to obtain borrowed money to invest. 

Example of Leverage

For example, an investor has ₹1,000 to invest in Stock T. However, Stock T itself costs ₹1,000. In this scenario, if the investor purchases Stock T, they will not have any money left to invest. So, in this case, the investor could use leverage and approach their bank or broker. Suppose the investor gets leverage of ₹ 500. They can use the leverage of ₹500 and ₹500 of their own to purchase Stock T. Suppose, after 3 months, the value of Stock T appreciates by 50% and goes to ₹1,500. The investor would have made a profit of 50% had they invested their own ₹1000. However, since out of the total money invested, only ₹ 500 was their own, the investor has made a 100% on their investment. The leverage can be easily paid off later in spite of the interest. 

On the flip side, if the value of Stock T falls by 50% to ₹500. Then, in this case, the investor is making a loss of 100%, as they are losing the entire ₹500 they put into the investment from their pockets. In the case where the investor did not opt for leverage, they would be using their own ₹1,000 to buy Stock T, and incur a loss of only 50%. Although, in terms of raw numbers in both scenarios, the investor is losing ₹500. But in the former case, in which the investor incurs a loss, they would also have to pay interest for the borrowed debt in the form of leverage. After incurring a loss, an interest amount would not feel significant. 

Unlike the aforementioned example, the amounts borrowed in the real world are not as small as ₹1,000. In the above example, the leverage ratio is 2:1 as the total position size is 1,000, but the investor only pays ₹500 from their own wallet. However, the leverage ratio could be as big as 30:1 or even bigger. Neither is it possible to claim leverage on each and every stock trading in the stock market. 

Conclusion

Both investors and traders can make use of leverage in the stock market to try and increase their return on investment. Investors who opt for using leverage not only purchase stocks but trade derivatives as well. Futures and Options contracts and derivatives of currency and commodities are highly speculative in nature. Trading these assets entails high risk, high reward, and a high capital requirement. Using leverage to trade these assets can further increase the risks as well as rewards. Only the most experienced investors who know how to manage their risk efficiently are able to use leverage to their advantage. Understanding the meaning of leverage in the stock market will benefit a new investor, but this does not mean that one should start using leverage without doing due diligence.

Frequently Asked Questions (FAQs)