Leverage Trading: What is Leverage Trading?
By: Alex Dixon
What is Leverage in Trading?
Have you ever used a screwdriver to open a can of paint, thrown a lacrosse ball, or used any type of lever to help you carry out a task? If so, you have used leverage before.
In finance, the term leverage is the same just applied to the financial world.
Leverage trading is a way to potentially amplify your gains at the cost of also amplifying losses.
Trading with leverage is simply trading a larger position than the capital one provides to put towards the position. It operates in tandem with margin in that one must have margin to trade with leverage.
In terms of stocks, the use of margin is the ability to borrow from a broker. This also allows traders to short positions, but let’s keep this one about leverage trading and margin.
How Does Leverage Trading Work?
Here is an example of how leverage trading works. If a trader has an account and decides to allocate $10,000 to a trade and their broker allows the borrowing of four times the margin (with the $10,000 being the base margin), this trader can place a trade of a $40,000 position. In this case, the trader would be borrowing $30,000 to place the trade. Of course, brokers charge interest to use margin.
A Real-Life Example
For a stock that is $100/share, rather than taking a trade of 100 shares as if it was a cash account, a trader can trade 400 shares.
The cool thing about this is that if the stock price goes from $100 to $110, rather than making a 10% return on $10,000, which would bring the account value to $11,000, traders can have a 40% return, bringing the account value to $14,000 using the same capital and making the same trade.
How About the Losses?
The wins are what make the use of leverage so attractive! Who wouldn’t want to make a 40% return over a 10% return? But of course, to every up there is a down, to every hot a cold, and to every yin a yang. Losses do the same thing.
If a trader is on the wrong side of the trade, the losses are also leveraged. In the example from before, let’s say that same stock drops from $100/share to $90/share. Without leverage, the account net value has dropped from $10,000 to $9,000. With the use of the 4 times leverage, the $10,000 account drops to a net value of $6,000.
Can Leverage Bring Your Trading Account to Zero?
How about if a price drops to $75/share? That $10,000 position is now worth $0. Without proper risk management in place, many traders have experienced their accounts worth dropping close to nothing very quickly because of leverage. In the trading world, an account going to zero is referred to as “blowing up an account”.
As stockbrokers have been around for a while, they know how to deal with these types of situations to protect themselves. If the value of the entire account drops below the threshold of the margin requirement, they will issue a margin call. In the case of a margin call, accounts get frozen, and funds or securities have to get deposited to bring the value of the account to the minimum margin requirement. If the account is not brought to the proper value, positions are liquidated.
How To Protect Yourself from Losing In The Stock Market
Luckily, with proper risk management, position-sizing, and practice, leverage is beneficial to traders and may yield higher returns for many traders.
How To Short Stock | Using Margin to Short Stock
Having a margin account also gives traders the ability to short stock positions.
Margin gives traders the ability to borrow, which includes borrowing shares of stock that they can sell before actually purchasing them.
If a trader thinks the price of a stock is going to drop and they wish to partake in taking a short position, they may borrow shares from their broker to sell and then pay back when they liquidate the position. Brokers charge interest for using margin in this way also.
Pattern Day Trading Rule: PDT Rule
When trading stocks or options with margin, be aware of the Pattern Day Trading Rule (PDT rule). A Pattern Day Trader is a trader who executes four or more day-trades (where the position is entered and exited in the same day session) provided that those trades represent 6% of the customer’s total trades in that same five trading day period for accounts less than $25,000. Since the PDT rule only applies to trading with margin, cash accounts are not affected by the PDT rule. Different brokers may also have their own additions to classify someone as a pattern day trader if the broker “knows or has reasonable basis to believe” that the customer will engage in pattern day trading.
Leveraged Products: Leveraged ETFs
There are also products available that use leverage by default, such as futures, options, and leveraged ETFs.
With these products, margin works a little differently. In the case of leveraged ETFs, they are typically designed to have movement 2 or 3 times their underlying asset. But just like any time one uses leverage, there is the downside risk and many leveraged ETFs have gone to near zero or zero.
Leveraged ETFs do not actually involve borrowing and can be traded in cash accounts, including retirement and education accounts, and brokers do not charge interest for holding long positions of these securities.
Futures and options have margin requirements every time they trade, which is based on the contract value, but no borrowing takes place here either. For example, one futures contract is for 5,000 bushels of corn, 1,000 barrels of crude oil, or $100,000 face value of treasury bonds, but someone would only need a fraction of the contract value in margin to use the leverage of these products.
Options work similarly in that options are contracts issuing the right or obligation to either buy or sell a security at a specified price. Since no borrowing takes place when using futures and options, brokers also do not charge interest.
Using leverage allows for the trading of larger positions than the capital provided. Margin, when referring to stocks, refers to the capability of borrowing while in options and futures it is the initial funds needed to control a contract.