What Is Leverage?
Psst: do you want to know a secret? There’s a way to make money using other people’s cash – and it’s completely legal. Introducing the nifty tool in every pro trader’s arsenal: leveraged trading.
Give me the lowdown. Leveraged trading is all about borrowing money to make a trade or longer-term investment. The basic principle is simple. Investment gains are always expressed as a percentage return: your Uber shares go up by 1%, say. If you’ve got $100 worth of those shares, you’ll stand to make $1 – better than nothing, but not great. But if you’ve got $10,000 worth of Uber shares, that 1% gain will make you $100 – enough to justify upgrading from the bus for a change.
The problem is, you might not have $10,000. And even if you do, it might be locked up in other things – you won’t want to risk all your money on a single bet, not least if you’ve been paying attention to some of your other Finimize Packs...
Borrowing can come to the rescue. With a margin account, you gain the ability to borrow money from a brokerage platform. And you can then use that money to make larger trades, magnifying any potential returns (never fear: we’ll look at a concrete example of how this works in the next session). Hopefully you’ll make a profit, in which case you can pay back the loan – while also pocketing a nicely boosted packet. Jacking up your trading in this way is called using leverage: just like a lever magnifies the force of a movement, leverage magnifies the power of your money.
But with great power comes great responsibility – and leverage is something you absolutely must use responsibly. Leverage can also magnify your losses, something that’s been the ruin of many a battle-scarred trader.
I’m scared... Don’t be! Although leverage can be dangerous, it can also be a very useful tool – so long as you know how to use it properly. In this Pack we’ll teach you just that, looking in detail at the benefits while also considering how to mitigate the risks. We’ll begin by looking at how leverage works in practice.
How Leveraged Trading Works
Give me an example of leverage. Let’s say Facebook shares are trading at $100, and you want to buy $1,000 worth. Your broker might have a margin requirement of 10%, which means that you’ll have to put in 10% of the amount you want to trade (you might see this written as a trade on 10% margin). So you put $100 into your margin account, and your broker puts through the $1,000 Facebook trade – lending you $900 of that.
You’re in luck – there aren’t any data breaches at Facebook that week – and the shares shoot up 10%. That means your total holdings are now worth $1,100. You sell the shares, return the borrowed $900 to your broker, and pocket the $200 difference (which includes your own original $100 bet). Well, not quite – you’ll have to pay the normal share-trading commissions, as well as a bit of interest to the broker in return for them lending you the cash. But still, everything’s comin’ up Zuckhouse.
Compare this scenario to one where you used your $100 without leverage. You’d have been able to buy just one Facebook share, and make just $10. That’s a 10% return – but by using leverage you could’ve doubled your money, scoring a 100% return. Not bad, right?
When you consider situations using more leverage, the potential gains can become quite astronomical. With a 1% margin, $100 could buy you $10,000 worth of a given investment. A 10% rise would deliver $1,000 in profits – a 1,000% return.
But what about if it goes wrong? You’re asking the right questions, Finimizer – there’s no such thing as a free lunch. Let’s imagine you make that 1% margin trade again, but Facebook gets caught selling your data to Martian advertisers and its shares lose 10% of their value, slipping down to $90. With a non-leveraged trade, you’d have lost just $10 of your $100 stake, or 10%. But with the heavily leveraged trade, your holdings are now worth $9,000. Since you’ve lost your stake and also have to repay your broker $9,900, you’re down $1,000 all in all – a 1,000% loss. Add on interest and fees, and you’ve done really badly. Oops.
Leverage can multiply your losses every bit as much as it can multiply your profits – which makes it a risky tool. But that doesn’t necessarily mean you should avoid it altogether. Next, we’ll look at how you can handle leverage sensibly.
Why Leverage Can Be Useful
Why use leverage? You’ve only got so much cash, and putting it all in one investment is risky – you’ll often hear Finimize preaching the benefits of diversification because it helps spread your risk. Nevertheless, you might still want to make a $1,000 bet on Facebook shares, and who are we to stop you? Leverage can help you here: it minimizes the amount of capital you need to make that bet.
Now, you could just buy $1,000 worth of Facebook shares. If the shares go up 10%, you’ll make $100 – and everything’s fine and dandy. But instead of putting all that cash on blue, you could use leverage instead. At a 50% margin, you’d only need $500 cash to make that $1,000 bet. The shares go up 10%, you sell, pay back your $500 brokerage loan and take away a $100 profit. That’s exactly the same return – but in the meantime, you’ve kept hold of half of your own cash to use for other purposes.
Even if things go south in this scenario, you’re okay: a 10% drop in the share price would lead to you making the same $100 loss in both the non-leveraged case and the 50% margin case (although some interest would also be payable in the latter). Leverage hasn’t changed your risk profile; you’re just using it to reduce the amount of capital you have to put up.
In fact, leverage can actually tip the scales in your favor by offering you the opportunity to use your freed-up cash to generate returns elsewhere. You could make another investment, buying shares of a company in a different sector or safer bets like government bonds. You could even stash it in a savings account if you’re feeling particularly responsible.
Are there other reasons to use leverage? In currency trading, price movements are often small – we’re talking fractions of a cent. That means that using small amounts of money won't generate meaningful returns – you need tens or even hundreds of thousands of dollars to play with. Most people obviously don’t have that sort of cash to hand, and so currency brokers will typically offer traders large leverage.
But while leverage has its place, the risks are very serious. Pick up your phone: you might just take a margin call.
The Risks Of Leverage
What can go wrong with leverage? As we saw in Session Two, using leverage in an attempt to maximize your gains could instead end up boosting your losses. Part of the problem is that it can make you greedy – when you see you’ve got the ability to borrow $10,000 you might instinctively want to use all of it, even if the prudent thing to do is just use $1,000.
Leverage can also quickly get intoxicating. Here’s investing legend Warren Buffett on the practice:
“When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
– Warren Buffett
What’s the *worst***-case scenario? If a leveraged trade starts going south, your broker might immediately start deducting cash from your account: it wants to be sure it’ll be repaid the full amount. But if your account balance dips below a certain level (in the US, at least 25% of the value of all your trades), you’ll receive a margin call*. Your broker will require you to deposit more funds to cover the losses. If you don’t do this quickly enough, it might forcibly sell your trading “positions”, pay itself back, and leave you with nada. Annoyingly, the trades could* rebound the very next day – but as your positions have been exited, that’ll be too late. Make sure you answer those calls…
Anything else to think about? You should always be aware of the interest rate you’re paying to borrow money. Different brokers charge different fees – popular trading app Robinhood charges a $5/month subscription to borrow $1,000, and on top of that you’ll need to pay 5% annual interest (calculated daily). These fees could eat into your profits, so make sure you take them into account when planning a trade.
Finally, note that lots of leveraged trading doesn’t actually involve you owning investments like stocks. Instead, you may be trading derivatives, the values of which are based on the actual stock prices. This means you won’t necessarily get paid dividends, for example.
Risks haven’t put you off? Great – now we’ll talk about how exactly to use leverage in practice.
How To Use Leverage
How do I use leverage? First of all, you’ll need to find a broker that offers margin trading – not all do, and even then you might need to open a special kind of account. Comparing fees across brokers is important, as is looking at their reputation – you don’t want to get caught out by unexpectedly quick margin calls, nor do you want them to fall asleep on the job and let you rack up massive debts without fair warning: some brokers let your account balance turn negative, meaning you could end up owing them money.
Once you’ve opened an account, you can start trading on margin. But there are legal limits to the amount of leverage you can use, and your broker will probably have its own even stricter rules. These vary from asset to asset: for example, the US central bank requires you to put down at least a 50% margin when trading stocks, but the rules are laxer for currency trades and futures (you could easily borrow 50 times the amount you put up).
Remember – just because you have lots of leverage available, that doesn’t mean you should use it all. Over-leveraging your position can turn molehills into mountains: values don’t have to move by much for you to get badly burned. Don’t put too much of your cash into a single trade (any more than 1% or 2%), and always use stop-loss orders to automatically sell your holdings if they fall below a certain price, thus limiting your losses – but be warned that in a free-falling market, there might not be any buyers and the stop-loss might fail you.
Are there other ways to use leverage? If you don’t want to borrow directly, you can buy into a leveraged exchange-traded fund (ETF) instead. Normal index funds track the value of an index; leveraged ones do the same thing, but… using leverage (gold star if you figured that out yourself).
That means that whereas a normal S&P 500 index fund will move up 1% when the index goes up 1%, a leveraged ETF will move up 2% (or even 3%, depending on how leveraged it is). Of course, that also means a 1% drop in the index translates to a bigger drop in the leveraged ETF.
The most important thing with leverage is to keep your head. Don’t get greedy, and think very carefully about the risks of what you’re doing – you should imagine the worst-case scenario for any trade before you do it, just so you know you can deal with the losses. If used correctly, leverage can be a powerful tool – just make sure you don’t get too fulcrum of yourself...
In this Pack you learned:
🔹Leverage involves you borrowing money to increase the size of a trade
🔹It can magnify your gains – and your losses
🔹Using leverage wisely can free up cash for you to use elsewhere
🔹But it’s easy to get greedy, gamble too much, and lose it all
🔹You can use leverage with a brokerage margin account, or with a leveraged ETF
