In the context of trading, leverage gives traders increased purchasing power by allowing them to borrow money for trades. With more money fueling their trades, they may potentially be able to earn much higher returns on their initial capital.
Using leverage also increases a trader’s risk and potential for losses, so only experienced traders should use it. Here are some of the key terms and concepts you’ll need to know if you are considering using leverage.
What Is Leverage Trading?
In leverage trading, traders use borrowed funds to buy assets like stocks on margin. Leverage trading can only be successful if the return on an investment is higher than the cost to borrow money.
Most stock investors use the cash they have available to trade stocks and other assets through brokers. They can only invest as much money as they have available, which limits their potential earnings.
Leverage trading can significantly increase potential earnings, but it is also very risky and so is usually only used by experienced traders.
How Leverage Trading Works
Leverage trading in a brokerage account consists of a trader borrowing money from the broker, then using that along with their own funds to enter into trades.
The key to understanding how leverage can help generate higher returns, but also greater losses, is that the funds borrowed are a fixed liability. Suppose a trader starts with $50, and borrows $50 to buy $100 worth of stock. Whether the stock’s value goes up or down from there, the trader is on the hook to give back $50, plus interest, to the broker.
Suppose the stock appreciates by 10%, and the trader closes out the position. They return the $50 they borrowed, and keep the remaining $60. That equates to a $10 gain on their $50 of capital, and a 20% return — double the return of the underlying stock.
On the flip side, consider what happens if the stock declines in value by 10%. The trader closes out the position and receives $90, but has to give the broker back the $50 they borrow. They are left with $40, a loss of $10, which is a 20% loss.
Brokers have limits on how much they’ll lend traders based on the amount of funds the trader has in their account, their own regulations, and government regulations around leverage trading.
Leverage Trading Terms to Know
There are several key terms to know in order to fully understand leverage trading.
Margin Requirement: This is the amount of funds a broker requires a trader to have in their margin account when entering into leverage trades. If a trader incurs losses, those funds will be used to cover them. Traders can also use securities they hold in their account to cover losses. Margin requirement is often a percentage. For example, at a leverage amount of 100:1, the margin requirement is 1%.
Margin call: If a trader’s account balance falls below the margin requirement, the broker will issue a margin call. This is a warning telling the trader they have to either add more funds to their account or close out some of their positions to meet the minimum margin requirement. The broker does this to make sure the trader has sufficient funds in their account to cover potential losses.
Buying power: This is the total amount a trader has available to enter into leverage trades, including both their own capital and the amount they can borrow.
Account balance: The total amount of funds in a trader’s account that are not currently in trades.
Used margin: When an investor enters into trades, some of their account balance is held by the broker as collateral in case it needs to be used to cover losses. That amount will only be available for the trader to use after they close out some of their positions.
Usable margin: This is the money in one’s account that is currently available to put into new trades.
Coverage: The ratio of the amount of funds currently in leveraged trades in one’s account to the net balance in their account.
Open position: When a trader is currently holding an asset they are in an open position. For instance, if a trader owns 100 shares of XYZ stock, they have an open position on the stock until they sell it.
Close position: The total value of an investment at the time the trader closes it out.
Stop-loss: Traders can set a price at which their asset will automatically be sold in order to prevent further losses if its value is decreasing. This is very useful if a trader wants to hold positions overnight or if a stock is very volatile.
Types of Leveraged Trading
There are a few different types of leverage trading, each with similarities and differences.
Trading on Margin
Margin is money that a trader borrows from their broker to purchase securities. They use the other securities in their account as collateral for the loan. If their leveraged trade goes down in value, a trader will need to sell other securities to cover the loss.
Many brokers also charge interest on margin loans. So in order for a trader to earn a profit, the security has to increase in value enough to cover the interest.
Leveraged ETFs
Some ETFs use leverage to try and increase potential gains based on the index they track. For example, there is an ETF that specifically aims to return 3x the returns that the regular S&P 500 index would get.
It’s important to note that most funds reset on a daily basis. The leveraged ETF aims to match the single day performance of the underlying index. So over the long term even if an index increases in value, a leveraged ETF might decrease in value.
Derivatives
Traders can also use leverage trading with derivatives and options contracts. Buying a single options contract lets a trader control many shares of the underlying security — generally 100 shares — for far less than the value of those 100 shares. As the underlying security increases or decreases in value, the value of the options contract changes.
Options are derivatives contracts that give buyers the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) an asset at a specified price within a certain period of time. Traders can choose to sell call options on a stock if they think it is going to decrease in value.
Options trading is one of the riskiest types of leverage trading. A trader could potentially lose an unlimited amount of money if they sell a call option and the underlying stock price skyrockets in value. If the option seller exercises the trade, the trader will have to purchase the associated amount of the underlying security to sell to the option seller. If the security has gone up a significant amount this could cost millions of dollars or more.
Deciding if Leverage Trading Is for You
Although there is potential for significant earnings using leverage trading, there is no guarantee of any earnings, and there is also potential for significant loss. For this reason leverage trading is often said to be best left to experienced traders.
If an investor wants to try leverage trading it’s important for them to assess their financial situation, figure out how much they’re willing to risk, and conduct detailed analysis of the securities they are looking to trade.
Setting up a stop-loss order may help decrease the risk of losses, and traders can also set up a take-profit order to automatically take profits on a position when it reaches a certain amount.
The Takeaway
Leverage trading is a popular strategy for investors looking to increase their potential profits, but it is very risky, especially for inexperienced traders.
If, however, you are an experienced trader and have the risk tolerance to try out trading on margin, SoFi can help. With a SoFi margin account, you can increase your buying power, take advantage of more investment opportunities, and potentially increase your returns.
Photo credit: iStock/ljubaphoto
*Borrow at 8.50%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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