Leverage in Stock Market
Leverage means using borrowed money to increase your trading positions in the stock market and potentially increase your returns. Think of it like a loan from the broker to purchase more shares than you can currently afford with your personal funds. Thus, using leverage means increasing your buying capacity without spending additionally from your own pocket.
Some examples include buying on futures and options, margin, and using leverage trading while borrowing to earn higher profits. For instance, futures contracts involve bigger amounts and brokers will ask you to pay just the margin for the deal (to be held by the broker). By using leverage you may enhance your profits in case the stock price increases.
For example, if you invest ₹1,000 with 2X leverage, you will trade with basically ₹2,000 and your profits will go up. The same principle applies to losses as well. If the stock price comes down, then your losses will also be magnified by the borrowed funds. You may lose the initial investment and owe more money to the broker.
Leverage Meaning in Share Market
In its most primary form, leverage trading is any type of trading that includes borrowing money or otherwise raising the number of shares involved in a deal beyond the amount of what you can afford if you paid in cash.
Trading on leverage is not necessarily a negative thing if you know what you're doing and understand the risks. When that isn't the case, it's incredibly dangerous, and you could lose a lot more money than you can afford.
How Does Leverage Work?
Traders usually offer a margin deposit which functions as the collateral for the borrowed money. The remainder of the trade value is then lent by the broker, enabling them to acquire larger positions in the market. Thus, exposure to the underlying asset increases, meaning that profits/losses are calculated on the entire position size and not only the margin.
The leverage ratio is another vital concept here. It is the ratio of the total exposure to the margin. For example, 5:1 indicates that the trader may control 5 times the amount of the margin deposit. So, if you’re investing ₹1 lakh and your broker offers 5:1 leverage, it means that you can trade positions worth a maximum of ₹5 lakh. You can then deposit the ₹1 lakh as margin/collateral and the remainder can be borrowed from the broker.
Brokers usually charge interest (on a per-day basis) for the borrowed amount and they may require additional margin deposits (maintenance margin) in case the value of the shares bought on margin come down due to unfavorable conditions in the market. This ensures that traders can cover any potential losses resulting from these market movements. In case the maintenance margin is not deposited, brokers may close the position automatically and recover their outstanding dues.
Markets you Can Use Leverage
Here are the markets that you can use to leverage trading in:
- An Index
A numerical presentation of the performance of a group of assets from a specific exchange, location, region, or sector is called an index. Indices can only be traded through instruments that replicate their price movements, such as CFD trading and ETFs because they are not tangible assets.
- Forex
The purchasing and selling of currencies for profit is known as foreign exchange or forex. It is the world's most actively traded financial market. As forex trading involves such minor changes, many people prefer to trade with leverage.
- Cryptocurrencies
Cryptocurrencies are digital currencies that function similarly to forex but are not regulated by banks or governments. Leveraged products allow traders to invest in big cryptocurrencies like bitcoin and Ethereum without risking a large amount of money.
How to Use Leverage in Stock Market
Here are the different ways of using leverage in the stock market:
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1) Margin Trading: |
Trading on margin is a simple example. Margin is money borrowed from your broker to purchase a security with the help of other securities in your brokerage account as collateral. |
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2) Leveraged ETFs: |
There are additional Exchange Traded Funds that employ leverage to alter their performance in comparison to the market. Inverse ETFs strive to produce the exact opposite of the benchmark index's performance. The 3x inverse Exchange Traded Fund seeks to triple the underlying index's negative performance. When the underlying index is negative, the 3x inverse Exchange Traded Fund will return a positive 3x return. |
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3) Trading Derivatives: |
Another method to trade with leverage is to utilize options. One hundred shares of the underlying security are typically involved in one options contract. Purchasing an options contract allows you to control 100 shares for a fraction of the price of purchasing 100 shares of a corporation. This means that tiny changes in the underlying security's price can result in substantial changes in the option's value. |
Benefits of Using Leverage Trading in the Stock Market
Here are the benefits of leverage meaning in the stock market:
- Leverage increases the amount of money accessible to invest in different markets. This means you'll be able to put money into different trade positions in your portfolio.
- Leverage is a loan from your broker that allows you to take a larger stake in the market. However, there are no obligations in the form of interest or commission with this 'loan,' and you could utilize it in any way you like when trading.
- Traders that use leveraged trading can increase their profits from profitable trades. Profits are made on the trade position that is controlled, not on the margin that is put down. This also means that traders can benefit handsomely even if the underlying assets only change little in price.
- Traders could utilize leverage to trade tools that are seen to be more expensive or prestigious. Some instruments have a premium pricing - which could keep many retail investors out. However - such markets or assets can be traded using leverage, exposing the average retail investor to the numerous trading opportunities they provide.
- Market price fluctuations frequently occur in high and low volatility cycles. The majority of traders enjoy trading because price changes generate profit. This means that low volatility times can be particularly irritating for traders due to the lack of price action. Leveraged trading lets the traders make more money even during these seemingly dull periods of low volatility.