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Stock Trading With Leverage: Is This Approach Too Risky for New Investors?

M ost amateur traders buy stocks using cash, while some pros trade with leverage. What is stock trading with leverage, and is this strategy too risky a venture for novice traders? Use this informative article to find out if it’s time to join the big-leaguers or if one should steer clear of making this common trading mistake.

 

Key takeaways:

  • In the stock market, leverage trading is borrowing capital from a broker to increase an investor’s position in the hopes of higher yields.
  • Stock leverage has the potential for bigger losses than trading stocks using one’s own capital.
  • Buying power is equal to the amount an investor has available — including leverage — to purchase securities and is greater than their actual cash account balance.
  • Trading using leverage does not increase the risk of the trade itself. It comes with the same uncertainty as using cash.
  • Maximum leverage is the biggest position an investor can take based on their amount of margin.
  • Leverage warnings are provided by financial agencies, such as the U.S. Securities and Exchange Commission (SEC), and brokerages that offer to open margin accounts.
  • Margin calls are unfortunate situations that require traders to either deposit more cash into their accounts or liquidate their positions.

What Is Trading Stock With Leverage?

Image via Flickr by SimpleFX

To understand how these kinds of trades work, it’s important to explain the concept of “leverage.” When a person uses leverage, they are trading on credit. The process starts by depositing an amount of cash in a margin account, then borrowing a more substantial amount of money from the broker.

This strategy enables investors to increase their exposure to the market by allowing them to pay less than the full amount of the investment out of pocket. Leverage is also related to margin, in that margin is the minimum amount of cash that one must have in order to trade using leverage.

To Leverage or Not To Leverage? This Is Definitely the Question

Leverage is a very complex financial tool. While it sounds fantastic in theory, the results of this approach can be quite different. For the experienced investor, trading in this manner has both advantages and disadvantages.

Pros of Leverage

  • Borrowing from a brokerage house minimizes the amount of capital a trader has to invest.
  • Instead of paying the full price to open a position, an investor only needs to come up with a small portion of the premium in cash.
  • Some instruments are relatively expensive, and their price can rule out those with little access to capital. Leverage allows them to participate in a more prestigious market and to trade more contracts.

Cons of Leverage

  • While leveraged trading requires less capital at the onslaught, it also comes with a loss risk.
  • It is important to keep track of open positions to avoid a “margin call.”
  • Buying options with leverage usually requires years of marketplace experience.

What Is a Leverage Ratio?

The term ‘leverage ratio’ refers to the number of shares or dollars a brokerage house is willing to loan an investor. This amount is directly related to the amount of capital a trader has on deposit. It’s expressed as a ratio, such as 2:1. In this case, someone could increase their position size by borrowing double the capital they already have.

All this buying power doesn’t come free, though. A broker requires a down payment for the privilege of buying on margin. This is how brokerage firms earn money when extending credit. In an ideal trade, the stock climbs above the strike price, the trader sells, and then they pay the broker back with interest. The investor keeps the balance as profit.

The sticky part comes if the stock price drops, and the trader finds themselves in a loss situation. They still owe the broker and will have to cover all losses incurred during the trade, including their capital, the broker’s margin, and interest on the loan.

What Is the Maximum Allowable Amount of Leverage?

Maximum margin limits vary by market. However, most brokers won’t exceed 50% of the value of anyone’s position when trading stocks. Trading on the foreign exchange market (forex) or futures contracts can have a larger allowable margin, up to 400 times higher. This means that even the smallest fluctuation in the market can result in substantial losses.

What Is the Difference Between Leverage and Margin?

Leverage and margin may be misconstrued by novice investors. However, they’re not the same thing. A trader uses its margin (borrowed money) to increase leverage (buying power).

Tips for Buying on Margin

In stock trading, the most common type of leverage is margin. As mentioned above, margin is a debt that’s owed to a broker. It’s the amount of money or assets they’re willing to lend a trader with which to invest — or leverage the market.

While people can usually borrow up to 50% of their collateral, traders don’t have to exercise that much margin. One may decide to borrow 5%, which makes managing the potential for loss that much easier. This is a particularly good idea if an investor’s risk tolerance is very low or when just getting into the leverage game.

In order to trade with leverage, people must open a margin account. It’s different than a cash account and usually comes with a more substantial minimum deposit, such as $2,000 or more. Before a broker will lend someone money, they’ll need to prove certain things, like net worth, for instance. The brokerage house’s goal here is to ensure the investor has the resources to pay back the loan in the event of a bear market.

Securities and Exchange Commission (SEC) Requirements

After leveraging stock with margin, the investor is required to keep a minimum amount of equity in their margin account. This money cannot be used to purchase additional options. It must sit there as a buffer. According to SEC, a minimum of 25% of the value of a person’s purchased equities must remain in the margin account at all times, while some brokers require a maintenance margin of up to 40%.

What Is a Margin Call?

If the value of an investor’s equity or leveraged securities drops below a specific point, the brokerage firm can require an investor to repay all or a portion of the loan. This practice is called a ‘margin call.’ This is an unfavorable circumstance for any trader — novice or veteran. At that point, the investor must make up the difference by making a cash deposit into the margin account or selling their securities.

Avoid Closing Positions at All Costs

If an investor ignores a margin call, the brokerage firm will likely start to cancel all of that client’s pending orders. If that doesn’t cover the leveraged amount, the investor’s portfolio of stock positions will be forcibly closed in a sequence using LIFO (last in, first out). Stock options will continue to be sold until the coverage ratio has reached the appropriate level.

If allowed to reach this point, trading using leverage carries a high degree of risk to one’s capital, and it’s possible to lose more than one’s initial investment. People new to trading with leverage are recommended to speculate only with money they can comfortably afford to lose.

Should New Traders Use Leverage in Stocks?

Leveraged trading could end up being a very slippery slope for some investors. However, only the trader can make that decision for themselves. It’s usually when an investor becomes reliant on margin accounts that they lose sight of the bigger picture. They may become overly confident in positions where they shouldn’t continue with a ‘rob Peter to pay Paul’ approach.

It’s the same reason some folks choose not to gamble. Is it better not to owe the broker money if an investor’s position goes sideways? Many investors are more comfortable trading small. Therefore, playing the market conservatively with cash may be a better strategy.

Consider learning how stocks move and why, focus on the rules, and take time to build knowledge and experience. At that point, there may be some attractive growth happening in that portfolio. Discipline is the key.

The Bottom Line

Some traders don’t recommend buying on margin, while some people swear by it. Leveraged trading could end up being a chancy game, especially if an investor is risking too much of their total net worth. The rush may be enjoyable, and so are the high potential profits, but the crash can be just as big an impact on the opposite end of that emotional spectrum.