You must have heard about leverage or leverage trading in the share market many times, but did you know what exactly leverage means? In this blog, we have discussed the same. So let's get started!
What is leverage?
Share market traders borrow money to invest in the stock market that allows them to invest more cash than they have in hand. This is called leverage trading or investing with leverage. Borrowing money to make an investment is the basic meaning of leverage. Using stock market leverage traders get the facility to increase their investment thereby increasing their return on investment, but there is a chance of losing more money than when buying stock using only the actual funds available. In the finance sector, leverage is a strategy that companies use to increase assets, cash flows, and returns, considering the risk of losses. There are two types of leverages in finance that are financial leverage and operational leverage. Leverage lets investors increase their buying power to a great extent and potential returns, as well as their risk.
How Does Leverage Trading Work?
The percentage of leverage you get depends on brokers and the norms of regulatory authorities. Traders decide to take leverage depending on their experience, risk-taking ability, current market status, or trading tools. If done wisely you can gain a fair amount of profit by leverage trading, but if you failed to choose the right trades it is extremely risky and you could lose a lot more than you can afford. Because you are using the borrowed money which you have to pay at any cost.
Margin is the money you borrow from your broker to buy a security, using other securities in your brokerage account as a guarantee. The minimum margin requirement is set at 50% by Federal regulations, which means you can borrow up to 50% of the price of security you want to buy. Some brokers may have higher requirements. Many brokers charge interest on margin loans, which increases the cost of investing with leverage.
Risks of Leverage Trading
Leverage trading amplifies potential losses. The worse about it is that you can lose more money than you have.
Your brokerage could initiate a margin call. If your account’s value falls below a set threshold compared to the money you have borrowed from a broker, your broker may demand you to deposit additional funds. This can happen because your broker worries about your ability to repay your debt if your investments continue to lose value.
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.
Buying shares in leveraged ETFs has risks. Most funds “reset” daily it means that they only aim to match the one-day performance of their index.
It is the total amount an investor has including leverage to buy securities. Because the investor is using leverage for this amount greater than his or her account balance.
Coverage or Risk Ratio
This is a fundamental indicator that the investor should always keep in mind. It shows the ratio of the net account balance concerning the leveraged amount, the money that will have to be paid out.
If the coverage or risk ratio falls below the minimum requirement to maintain the leveraged position trader will issue a “margin call”. A margin call is a warning to the investor that his or her excessive exposure represents a risk that exceeds levels permitted by the bank.
This occurs once the broker has sent the corresponding warnings about exposure levels i.e. the margin calls and starts to cancel all the pending orders of the client. Pending orders are the orders that are placed in the market but not yet executed. If the leveraged amount has still not been covered, after 100 percent canceling these orders, the investor's stock positions in the portfolio will be automatically closed in a certain sequence. The investor himself must manage his or her market risks, closing positions before the coverage ratio reaches the minimum required level.
In the stock, market leverage gives a chance to increase the returns on your trade. But it also has risks involved. If you are smart and balance your moves, you can benefit. There is always the problem of being over-leveraged, so be aware of that. It can quickly drain your account if things go wrong. So, make sure you track positions, use the stop loss feature, and don’t waste all your income or funds.