Trading Stocks With Leverage
Most amateur traders, like buy-and-hold traders, trade using cash. This means that if they want to buy $10,000 worth of stock, they must have $10,000 in cash in their trading account. Professional traders use leverage (debt), meaning that if they want to buy $10,000 worth of stock, they only need a small percentage of the amount that they wish to trade.
Learn how traders use leverage safely and how trading with leverage carries the same amount of risk as trading with cash.
How Is Leverage Used?
Leverage trading is trading on credit by depositing a small amount of cash and borrowing a more substantial amount. For example, a trade on the EUR futures market has a contract value of $125,000. You can make the same trade with approximately $6,000 in cash by using leverage. Leverage is related to margin, which is the minimum amount of cash that you must have to trade using leverage. Thus, $6,000 is the margin requirement 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 by using leverage is dangerous and a quick way to lose money. This is mainly because of the various warnings 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 leveraged trading.
Leverage warnings are designed to keep novice traders and investors from jumping into trading with borrowed funds. There is nothing wrong with leveraged trading if you know what you're doing.
These warnings remind you that trading by 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. These warnings, however, can be slightly misleading.
Leverage Is a Legal and Efficient Use of Capital
Trading by using leverage allows you to trade in markets that would otherwise be unavailable. It lets you trade more contracts (or shares or forex lots, for example) than you'd be able to afford without it, and it holds the same risk as using cash.
Examples of Stock Trading With Leverage
Both stocks and futures can be traded by using leverage, incurring no more risk than trading by using cash. It helps to see some examples to understand how risk doesn't change.
- Symbol: XYZ
- Trade: Long 1,000 shares
- Tick Value: $10 per $0.01 change in price
- Entry Price: $125.50
- Target: $126
- Stop-Loss: $125.25
If you traded by using cash, you would need $125,500 to enter the trade. If it were profitable (by reaching its target), you'd make a profit of 50 ticks and receive $500 in profit (50 ticks x $10 per tick). If not (by reaching the trade's stop-loss), you would lose 25 ticks and $250 of your original capital (25 ticks x $10 per tick).
If you were to use leverage, you would only need $37,650 in cash to enter the trade. If it were profitable, you would make the same profit of $500 (50 ticks x $10 per tick). If not, you'd still only lose 25 ticks and the same $250 of your original capital (25 ticks x $10 per tick).
The profit/loss outcome of the trade is identical regardless of whether the trade is made by using cash or leverage, because the number of shares traded is the same (1,000 shares in the example).
- 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 you trade by using cash, you would need $125,000 to enter the trade (the value of the contract). If it were profitable (by reaching its target), you'd make a profit of 100 ticks and receive $1,250 in profit (100 ticks x $12.50 per tick). If not (by reaching the trade's stop-loss), you would lose 20 ticks and $250 of your original capital (20 ticks x $12.50 per tick).
If you trade by using leverage, you would only need approximately $6,000 in cash to enter the trade (the margin requirement for the EUR). If it were profitable, you would make the same profit of $1,250 (100 ticks x $12.50 per tick). If not, you'd still lose the same $250 of your 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 by using cash or leverage, because the tick value is the same ($12.50 per tick for the EUR futures market).
Leverage Risk Is the Same as Using Cash
Trading by using leverage is an efficient use of trading capital that is no riskier than trading using cash. Additionally, it can reduce risk, which is why professional traders trade by using leverage for every trade that they make. If you are still trading through a cash account, modifying your account or opening a new leverage (or margin) account can help you start trading by using leverage.