Using leverage in your trades gives you the option to trade a large number of shares or contracts using only a small amount of trading capital, known as margin. Some experts warn that novice traders should only trade cash-based markets and avoid trading highly leveraged markets, such as the options and warrants markets. Other experts do not see it this way. For some traders, even new ones, trading using leverage is no more risky than non-leveraged trading. For certain types of trading, the more leverage that is used, the lower the risk becomes.
Why Leverage Is Thought of as Risky by Some
Leverage is commonly believed to be high risk because it magnifies the potential profit or loss that a trade can make.
For instance, a trade using $1,000 of trading capital could have the potential to lose $10,000 of trading capital. This belief is based on the premise that if a trader has $1,000 of trading capital, they should not be able to lose more than $1,000. Further, they should only be able to trade $1,000, such as by buying 100 shares of stock at $10 per share.
A trader using leverage would be able to take that same $1,000 of trading capital to trade perhaps $4,000 worth of stock by buying 400 shares of stock at $10 per share. This sounds risky, right? In theory, it is. But there is a better way to look at it beyond the way an amateur trader looks at leverage.
The Truth About Leverage
Leverage can be a good way to get the most out of your trading capital. It is valued by expert traders because it allows them to trade more contracts or shares with less trading capital.
Leverage does not alter the potential profit or loss that a trade can make. It reduces the amount of trading capital that must be used, thereby releasing trading capital for other trades.
For instance, a trader who wants to buy 1,000 shares of stock at $20 per share would only require perhaps $5,000 of trading capital. This leaves the remaining $15,000 available for other trades. This is the way that a professional trader looks at leverage.
In addition to being a good use of trading capital, leverage can also reduce the risk for certain types of trades. For example, a trader that wanted to invest in 10,000 shares of an individual stock at $10 per share would require $100,000 worth of cash. All $100,000 of that money would be at risk. Instead, a trader who wants to invest in exactly the same stock with exactly the same potential profit or loss (i.e., a tick value of $100 per $0.01 change in price) using the warrants markets (highly leveraged markets), would only need a fraction of the $100,000 worth of cash. This amount could be around $5,000, and only that $5,000 would be at risk.
There is always some risk when trading on the stock market, and margin trading is no exception. The newer you are at trading, the more you should be sure you understand the risk vs. reward of trading in general.
Trade Using Leverage
Some savvy traders believe the more leverage, the better. Expert traders will choose highly leveraged markets over non-leveraged markets much of the time. Telling new traders to avoid trading using leverage is essentially telling them to trade like an amateur instead of a professional.
Every time that I trade a stock, I always use the highest leverage I can. This is usually in the options and warrants markets. I would never trade a stock without using leverage. The same goes for all of the professional traders that I know.
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