What is Leverage in Trading? The Complete Guide

Rohit had been trading in the stock market for over a year. One morning, he heard about a major merger between an Indian telecom company and a foreign giant. Based on his market understanding, he was confident the company’s share price would rise. Rohit invested a significant portion of his available funds in that stock and, by the end of the day, made a profit of nearly Rs. 10,000.

While he was pleased with the outcome, one thought kept bothering him. Had he invested a larger amount, his profits could have been much higher. Unfortunately, he had only limited funds. That’s when a friend introduced him to leverage trading. Now, Rohit could take much larger trading positions with only a small amount of capital, potentially amplifying his returns.

Are you excited to know more about this concept of leverage trading? This blog explains the meaning of leverage in trading in simple terms, along with the associated risks and benefits, to help you understand whether it is right for you.

What is Leverage in Trading?

Leverage in trading refers to the ability to control a larger trade position using a relatively small amount of capital. In simple terms, it allows you to borrow money from a broker to increase your trading amount. Leverage trading can be a double-edged sword. It can amplify your profits, but it can also magnify your losses.

Consider this example to understand the meaning of leverage in trading better. Suppose a broker is offering 10x leverage on your investments. It means that you can multiply your position size by 10 times the amount of your initial trading capital. So, if you are trading with an initial capital of Rs. 1 lakh, you can take positions worth Rs. 10 lakhs. If the market moves in your favour, your gains will be calculated on the full position of Rs. 10 lakhs and not on your initial capital, i.e., Rs. 1 lakh.

This quote from Warren Buffett sums up the leverage in trading meaning perfectly: “When you combine ignorance and leverage, you get some pretty interesting results.” If used wisely, leverage trading can dramatically increase your returns. On the flip side, it can have a devastating effect on your capital if done recklessly.

How Leverage Works in the Share Market?

Leverage trading in the share market works by allowing you to open positions that are larger than the actual amount of money you have in your trading account. This is done through a system called margin. Margin is the minimum amount of capital you must deposit to open a leveraged position. The broker funds the remainder of the trade value. This entire process is based on the leverage ratio.

The leverage ratio is the ratio of the trading position you can control to the margin money you have deposited. For instance, if your broker is offering a leverage ratio of 10:1, it means that you can control trading positions of up to ten times the amount of the margin deposit. So, if your margin deposit is Rs.10,000, you can control trading positions worth a maximum of Rs.100,000.

Your broker may charge interest on the borrowed amount (usually on a per-day basis). Additionally, if the market moves in an unfavourable direction, your broker may require you to deposit an additional margin. In case you fail to deposit the margin amount, the broker may close your positions automatically.

Types of Leverage Used in Trading

Leverage trading can take the following forms, depending on the market, the trading instrument, and the period for which a position is held:

Margin Trading

This is the most common type of leverage trading and is used for trading shares in the stock markets. Margin trading allows you to borrow funds from your broker and use them to purchase shares of companies. You are only required to pay an upfront amount (known as margin money), and your broker will finance the remainder of the trade value. Other securities in your trading or Demat account will be used as collateral. It means that if the market moves in an unfavourable direction or if you are unable to repay the borrowed amount, the broker may sell off your securities to recover dues.

Futures & Options Leverage

You can also utilise leverage by buying derivative contracts such as futures and options (F&O). These contracts give you the right/obligation to buy/sell a specific volume of shares on or before a pre-determined future date for a pre-determined price. Depending on the contract type, you may be required to pay a premium or margin amount. Buying derivatives contracts allows you to control hundreds or even thousands of shares of a company by paying only a fraction of their price.

Intraday Leverage

Intraday leverage is available for trades that are completed within the same trading day. Brokers often offer higher leverage for intraday trading as compared to margin trading. It is because the positions are squared off before market close and not carried overnight.

Pros and Cons of Leverage Trading

Leverage trading can be a powerful tool if used wisely. However, it also carries significant risks. You must understand both pros and cons before diving in. Advantages of Leverage Trading

Amplified Profits

One of the biggest advantages of leverage trading is that it helps you amplify your profits. Profits are calculated on the total trade positions you control and not on the margin money you have deposited.

Capital Efficiency

Leverage trading allows you to use your capital more efficiently. Instead of locking your funds in a single trade, you can open multiple positions even with limited capital.

Ability to Take Larger Positions

With leverage trading, you can take larger market positions that would otherwise be unaffordable.

More Trading Opportunities

Leverage in trading allows you to explore more opportunities apart from taking delivery of shares. You can try intraday trading, F&O trading, etc.

Risks of Leverage Trading

Amplified Losses

Leverage trading can amplify your losses just like profits. If the market moves in an unfavourable direction, you can lose a significant chunk of money.

Margin Calls

If losses exceed a certain limit, brokers issue margin calls. In such cases, you may have to add more funds to your trading account or risk forced position closure.

Potential to Lose Your Assets

When you use leverage trading to buy shares, other securities in your portfolio are used as collateral. You could lose your assets if the market moves in an unfavourable direction.

Higher Volatility Exposure and Emotional Pressure

Leverage in trading increases exposure to market volatility, which can create emotional stress and lead to poor decision-making.

Margin Calls and Risk Management in Leverage Trading

Margin calls are a crucial aspect of leverage trading. They occur when the value of your trading account falls below the minimum margin required by the broker. This usually happens when the market moves in an unfavourable direction, and you start incurring losses. Your losses, in turn, reduce your margin money.

When a margin call is issued, it means that you must add more funds to your trading account to continue holding your positions. If you fail to do so, the broker may close your positions automatically, often resulting in abrupt losses. Hence, it is crucial to maintain adequate margin levels and deploy risk mitigation strategies when using leverage in trading.

Below are a few risk management tips that can help:

• Leverage wisely and avoid overleveraging at all costs.
• Set clear stop-losses and targets.
• Maintain an adequate margin balance.
• Avoid emotional trading.
• Have a clear exit strategy.

Who Should Use Leverage and When?

While leverage trading can amplify your profits, it can do the same to your losses. That is why not everyone should use leverage in trading. It is usually suitable only for traders who have a clear understanding of the market and risk management. For rookie traders, using leverage can lead to rapid losses and capital erosion.

To determine if you should use leverage in trading, analyse the following factors:

Risk Tolerance: Leverage trading involves significant risks and exposes you to increased market volatility. Think about it only if you have a high-risk tolerance capacity.

Trading Experience: Leverage trading is not suitable for inexperienced traders. You must know how to analyse price trends, control emotions, and follow disciplined trading strategies.

Financial Goals: Leverage trading can help you amplify your short-term returns with minimal investment. But if you’re looking for capital preservation and long-term growth, it might not be suitable for you.

To Conclude

Leverage trading can be a powerful tool when used with the right knowledge and discipline. While it allows traders to take larger positions with limited capital and potentially enhance returns, it also increases the level of risk significantly. Understanding the meaning of leverage in trading, how it works, and the associated pros and cons is essential before using it in real time.

In practice, leverage is often approached conservatively to avoid overleveraging. Trades are typically entered with predefined stop-loss levels and targets, while emotional decision-making is avoided. Having clear exit strategies in place beforehand is commonly seen as an important part of managing leveraged positions.

Sources:

Investopedia
EconomicTimes
Economic Times