How Does Leverage Trading Work?
Leverage trading, in the most basic sense, is any type of trading that involves borrowing money or otherwise increasing the number of shares involved in a trade beyond the number of shares you could afford when paying in cash.
It’s not a bad thing to trade on leverage if you know what you’re doing and understand the risks. But if that’s not the case, it’s extremely risky and you could potentially lose a lot more than you can afford to.
Here are the different ways you can use leverage to trade in stocks:
Trading on Margin
A simple example is trading on margin. Margin is money you borrow from your broker to buy a security, using other securities in your brokerage account as collateral.
Note
Federal regulations set the minimum margin requirement at 50%, meaning you can borrow up to 50% of the price of a security you want to buy. Some brokers may have higher requirements.
For example, you have $10,000 in your brokerage account and want to invest in Company XYZ. XYZ is currently trading at $50 per share.
If you purchased shares with just the cash you have, you could afford 200 shares. If you decide to use margin, borrowing $10,000 from your broker, you could buy 400 shares instead. This amplifies your potential gains and losses.
If the share price rises to $60, you’d earn a profit of $2,000 or 20% if you invested with cash. If you used margin, you’d earn $4,000 or 40% of the cash you invested.
However, if the price dropped to $40, you’d lose $2,000 with a cash investment and $4,000 if you invested using margin. Remember: You have to pay back the money you borrow from your brokerage.
You’d lose all of the money you invested if you used margin and the stock price of XYZ fell to $25. You’d owe money to the broker even after selling your shares if the price fell below $25.
Note
Many brokers also charge interest on margin loans, increasing the cost of investing with leverage.
Trading Derivatives
Options are another method of trading with leverage. One options contract typically involves 100 shares of the underlying security. Buying an options contract lets you gain control over 100 shares for far less than the cost of buying 100 shares of a company. This means that small changes in the price of the underlying security may cause large changes in the value of the option.
Imagine you think that XYZ is going to lose value instead of gain value. Instead of buying shares using margin, you might decide to sell call options on the stock, setting a strike price of $40. Call options give the option holder the right, but not the obligation, to buy shares from the option seller at the set price.
If the price of XYZ remains above $40, the option holder will likely exercise the option, forcing you to buy shares on the open market to sell those shares to them for $40 each. One contract covers 100 shares, which means that if XYZ Is trading at $41 when the option is exercised, you’ll lose $100. If it’s at $50, you’ll lose $1,000.
Leveraged ETFs
There are also ETFs that use leverage to try to affect how they perform compared to the market.
Note
ETFs typically track a particular index; leveraged ETFs aim to track the gains or losses of the index they are benchmarked to. For example, a 3x S&P 500 ETF such as the Direxion Daily S&P 500 Bull (SPXL) aims to return 3x or 300% the returns of the S&P 500 on a daily basis.
There are also inverse ETFs that aim to deliver the opposite performance to the performance of the benchmark index. A 3x inverse ETF aims to triple the opposite performance of the underlying index. So if the underlying index is negative, the 3x inverse ETF such as ProShares UltraShort (QQQ) ETF would return a positive 3x return.
The Risks With Leverage Trading
One of the primary risks of leverage trading is the fact that it amplifies your potential losses, potentially to the point where you can lose more money than you have available.
Margin Risks and Margin Call
For example, if you use margin to double your purchasing power, you double all of your gains and losses. That means that if a stock you buy loses more than 50% of its value, you’ll lose more than 100% of the cash you had available to invest.
Another risk is that your brokerage could initiate a margin call. If your account’s value falls below a set threshold compared to the money you’ve borrowed, your broker may demand you deposit additional funds. This can happen because your broker worries about your ability to repay your debt if your investments continue to lose value.
Note
If you fail to deposit sufficient funds to meet a margin call, your broker may forcibly sell some of your securities to pay itself back, sometimes without notification. Your broker also decides which securities to sell and has the right to increase margin requirements at any time.
Potential for Unlimited Loss With Options
Some leverage trading strategies, particularly options, have potentially infinite risk.
If you sell a call option and the option seller exercises it, you need to buy 100 shares of the stock to sell to the person who holds the call. If the strike price is $50 and the market value for the stock is $60, you’ll lose $1,000. If the market value is $70, you’ll lose $2,000. If the market value of a share is $1,000, you’ll lose $95,000.
The higher the market value of the share rises, the greater your losses will be. Because there theoretically is no limit to how high a share’s price can rise, there is no limit to how much money you can lose. Imagine each share wound up trading for $1 million or $10 million. You’d lose hundreds of millions or billions of dollars.
While this scenario isn’t likely, because there’s no limit to how high a stock can rise, it’s important to understand that the risk of these kinds of options can be immense.
Leveraged ETFs Not for the Long Haul
Even buying shares in leveraged ETFs has risks. Most funds “reset” daily, meaning they only aim to match the one-day performance of their index. Over the long run, their returns can significantly diverge from the overall returns of the benchmark.
For example, according to the SEC, between December 1, 2008, and April 30, 2009, an index rose 8%. Meanwhile, a 3x leveraged ETF tracking the index fell 53%, while a 3x inverse ETF tracking the index declined by 90%.
Key Takeaways
- Trading with leverage involves borrowing money to invest in the stock market
- Leverage increases your risk for loss, to potentially unlimited loss from bad investments
- Your broker may sell investments on your behalf if their values drop below a set amount
Frequently Asked Questions (FAQs)
Is leverage trading dangerous?
Leverage trading can be dangerous because it amplifies your potential investment losses. In some cases, it’s even possible to lose more money than you have available to invest.
Is leverage trading good?
Leverage trading can be good because it lets investors with less cash increase their buying power, which can increase their returns from successful investments.
Do you have to pay back leverage?
Yes. If you borrow money to invest, such as by trading on margin, you will have to pay it back to your broker. Many brokers also charge interest on margin loans, increasing the cost of investing with leverage.
