How To Invest In Stocks And Increase Returns With Leverage
Definition of leverage
The stock market is all about using money to make money. The more capital you have, the more you can make. However, capital is usually a finite resource. Most people don't have lots of capital to throw around. There is a clear limit to what they have.
People are sometimes confronted with the situation, where they don't have enough capital. They know something will soon rise or fall in price, but cannot acquire the necessary assets. They have a clear idea of what they want to do, but can't do it.
What they need is a way of increasing the amount of capital they have available. The solution here in the world of finance is called leverage, which is any method that results in gains or losses being multiplied.
How to increase profit margin with leverage?
In trading, leverage can be used as a substitute to make up for insufficient available capital. This can be illustrated with following example.
- Investor A only has $5000 but wants 200 shares of company X priced at $50 each. Using a margin account, he is able to purchase $10,000 worth of shares with only $5000.
- Assume the share price of company X rises from $50 to $55. Investor A has gained $1000, since his shares are now worth $11,000. Without leveraging, his gain would only have been $500 with 100 shares. Using leverage, he doubled his gain.
- Now assume the share price of company X goes down to $45. Investor A has lost $1000 due to leverage. Without leverage, he would have had only 100 shares and lost only $500.
In the example above, investor A was leveraged 2:1. However, much greater ratios are possible. In currency trading, it's not unusual to be leveraged 50:1 or even more. Needless to say, this kind of trading carries with it great risk.
Leverage puts someone in a position to post much greater gains that would otherwise not be possible. The price for this is to run the risk of suffering much greater losses. It is therefore imperative that there is a high probability of success if one is to use leverage.
How to use leverage?
Those interested in being leveraged have several choices.
- Buying on margin
- Leveraged Exchange Traded Products
- Using Options
What is buying on margin?
The oldest and best known method is through what's called margin. Margin is a form of collateral and involves borrowing capital from your broker. This allows you to invest with much greater amounts of capital using such a margin account.
To maintain this account, you must meet the margin requirements. These consists of an initial requirement when you open a position and a maintenance margin requirement to keep the position open.
Dropping below margin requirements can result in margin call. You then have a certain amount of time to either close the position or add more capital to make up for the shortfall in margin. Failure to take any action can result in your position being liquidated by your broker to raise the required capital.
Note also that margin requirements may be raised or even lowered at any point in time.
What are Leveraged Exchange Traded Products?
Leveraged Exchange Traded Products are similar to regular Exchange Traded Products in that they also track an underlying index. They can be bought and sold like all other equities. However, they also attempt to multiply the returns of the underlying index, usually by two or three times.
Using Leveraged Exchange Traded Products can be problematic. For starters, they do not always track their underlying index accurately. It's not unusual to have the underlying index rise with no effect on certain Leveraged Exchange Traded Products. This is especially the case when they track futures contracts which often roll over.
These problems make Leveraged Exchange Traded Products only suitable at best for very short term or day trading. Any other use is not recommended.
What are Options?
An option is a contract which gives you the right, but not the obligation, to buy or sell an underlying financial instrument at a strike price on or before an expiration date. The right to buy is a call option for those who think prices will rise and the right to sell is a put option for those who think prices will fall.
Options and how their pricing is determined is a very broad topic, but relies on what's known as the Black-Scholes Model. It's not possible to cover everything comprehensively in one article.
Options are the most complex way of leveraging, but also the most flexible. They allow a wide range of trading strategies, which otherwise are not possible. They are best suited for those experienced in all the intricacies that options entail.
Leverage is a useful tool in the hands of the informed investor and a dangerous tool in the hands of the uninformed investor. It is important that anyone looking to leverage do so only after sufficient training and learning.
Leverage a tool that must be handled correctly and with care. It is only to be used at the appropriate time and situation. Failure to do so can and will have disastrous consequences. Always remember that it is better to be safe than sorry.