The Risks of Stock Trading With Leverage

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Most amateur traders, like buy-and-hold traders, trade using cash, meaning that if they want to buy $10,000 worth of stock, they must have $10,000 in cash in their trading account. Professional traders trade using leverage, meaning that if they want to buy $10,000 worth of stock, they only need a small percentage of the amount that they want to trade. Trading using leverage is trading on credit by depositing a small amount of cash and then borrowing a more substantial amount of cash. For example, a trade on the EUR futures market has a contract value of $125,000, but by using leverage, the same trade can be made with approximately $6,000 in cash.

Leverage is related to margin in that margin is the minimum amount of cash that you must have to be allowed to trade using leverage. In the above example, the $6,000 is the margin requirement that is set by the exchange for the EUR futures market, and the remaining $119,000 is the leveraged amount.

Pay Attention to Leverage Warnings for Stocks

Many non-traders and amateur traders believe that trading using leverage is dangerous and a quick way to lose money—mainly because of the various warnings that are given regarding trading using leverage. Leverage warnings are provided by financial agencies, such as the U.S. Securities and Exchange Commission (SEC), and brokerages that offer to trade using leverage. These warnings remind you that trading using leverage carries a high degree of risk to your capital; it is possible to lose more than your initial investment, and you should only speculate with money you can afford to lose. With warnings like this, it is no wonder that many people consider trading using leverage to be dangerous. The warnings, however, can be slightly misleading.

Leverage Is a Legal and Efficient Use of Capital

The reality is that professional traders trade using leverage because it is an efficient use of their capital. There are many advantages to trading using leverage, but there are minimal disadvantages. Trading using leverage allows traders to trade markets that would otherwise be unavailable, and allows them to trade more contracts (or shares, forex lots, etc.) than they would otherwise be able to afford. Trading using leverage does not is increase the risk of a trade; it is the same amount of risk as using cash.

Examples of Stock Trading With Leverage

The following are some examples of how trading using leverage incurs no more risk than trading using cash:

Stock Trade

  • Symbol: XYZ
  • Trade: Long 1000 shares
  • Tick Value: $10 per $0.01 change in price
  • Entry Price: $125.50
  • Target: $126
  • Stop-Loss: $125.25

If the above trade is traded using cash, the trader would need $125,500 in cash to enter the trade. If the trade were profitable (by reaching its target), they would make a profit of 50 ticks, and receive $500 in profit (50 ticks x $10 per tick). If the trade were not profitable (by reaching its stop-loss), they would lose 25 ticks and $250 of their original capital (25 ticks x $10 per tick).

If the same trade is traded using leverage, the trader would only need $37,650 in cash to enter the trade. If the trade were profitable, they would make the same profit of $500 (50 ticks x $10 per tick). If the trade were not profitable, they would still only lose 25 ticks and the same $250 of their original capital (25 ticks x $10 per tick).

The profit/loss outcome of the trade is identical regardless of whether the trade is made using cash or leverage because the number of shares traded is the same (1000 shares in the example).

Futures Trade

  • Symbol: EUR
  • Trade: Long 1 contract
  • Tick Value: $12.50 per $0.0001 change in price
  • Entry Price: $1.2800
  • Target: $1.2900
  • Stop Loss: $1.2780

If this trade is traded using cash, the trader would need $125,000 in cash to enter the trade (the value of the contract). If the trade were profitable (by reaching its target), they would make a profit of 100 ticks, and receive $1,250 in profit (100 ticks x $12.50 per tick). If the trade were not profitable (by reaching its stop-loss), they would lose 20 ticks and $250 of their original capital (20 ticks x $12.50 per tick).

If the same trade is traded using leverage, the trader would only need approximately $6,000 in cash to enter the trade (the margin requirement for the EUR). If the trade were profitable, they would make the same profit of $1,250 (100 ticks x $12.50 per tick). If the trade were not profitable, they would still lose the same $250 of their original capital (20 ticks x $12.50 per tick).

The profit/loss outcome of the trade is identical regardless of whether the trade is made using cash or leverage because the tick value is the same ($12.50 per tick for the EUR futures market).

The Risk of Using Leverage Is the Same as Using Cash

Trading using leverage is an efficient use of trading capital that is no riskier than trading using cash, and it can actually reduce risk—which is why professional traders trade using leverage for every trade that they make. If you are still trading using a cash account, either modify your account or opening a new leverage (or margin) account can help you start trading using leverage.