Leverage Trading: What You Need to Know Before Buying on Margin

leverage trading

I’m not a fan of leverage trading. I don’t like buying on margin, and neither do most of my top Trading Challenge students. However, you need to understand leverage trading to help fully immerse yourself in the stock market.

The idea behind leverage trading is to increase your potential payout on a play. However, it doesn’t always work out the way you want, and it can prove dangerous for your portfolio and trading account — especially when you’re new to the stock market.

I prefer to keep things simple. I buy, sell, and short stocks — mostly penny stocks — for short-term profits. I also have larger investments that I hold for longer periods of time, but that’s not how I initially made my wealth.**

When students ask me about leverage trading and buying on margin, I caution them against it. I do, though, expect them to learn what it is, how it works, and why it’s not the best idea.

What Is Leverage Trading?

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Analyzing data. Close-up of young businessman looking at the data presented in the chart while working. Via shutterstock.com

In the stock market, leverage trading is using borrowed shares from your broker to increase your position size in a play so you can potentially make more money on the other side. Options trading, futures contracts, and buying on margin are all examples of leverage trading, but buying on margin is perhaps the riskiest.

When you buy on margin, you’re essentially financing your position in the stock.

It’s just like buying a car. For example: Say you want a new SUV and you talk the salesperson down to $30,000. You don’t have $30K in cash, so you put $2,000 down and finance $28,000 over five years. Every month, you pay the lender your car note, which includes the principle (the amount financed) and the interest (money paid to the lender in exchange for financing you).

People do this every day with cars and other physical assets, so it doesn’t sound dangerous. But even a car purchase can leave you in financial trouble.

Let’s say you put $2,000 down on your new car and drive it off the lot. Three days later, you total it in an at-fault accident. The insurance company pays the car’s market value, which has already depreciated below what you paid for it. In other words, you have to keep paying off your car note even though you don’t have a car.

That’s sort of what often goes wrong with leverage trading.

How Does Leverage Trading Work?

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Stock Market Investment ID:534465157 created by g-stockstudio – Shutterstock.com

Leverage trading works by allowing you to borrow shares in a stock from your broker.

For example:

Say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.

Similarly, you could use buying on margin to increase your leverage. Instead of investing in options contracts, you buy a certain number of shares. Leverage is always expressed as a ratio, such as 2:1. In that case, you could double your position size by borrowing twice what you actually buy.

When you exit your position, you have to settle up with your broker. You’re responsible for paying back the broker for the shares you borrowed. Whatever you have left is your profit, minus your own initial investment in the shares.

2:1 Leverage Example

As mentioned above, leverage is expressed as a ratio. 2:1 leverage means you can borrow twice the amount of your investment from your broker.

For example: Let’s say you want to invest $100,000 in a stock, but you only have $50,000 in your trading account. Using leverage, you could buy on margin at 2:1, giving you $100,000 to invest.

It doesn’t come free, though. You have to make an initial deposit or down payment to your broker for the privilege of buying on margin. It’s sort of like the car buying example above. That’s how the broker makes money from extending margin.

But what happens to your investment?

Let’s say you bought $100,000 worth of stock at $100 per share. The stock climbs to $103, and you sell.

At that point, you have to return the borrowed shares or money to your broker. The brokerage firm extended $50,000, so you owe that back, plus any interest required. The rest you keep as profit.

If the stock price moves in the other direction, though, you’ll still have to pay back your broker. Plus, you’ll have to cover any losses your broker incurred during the trade as well as your own.

Buying on Margin

Buying on margin simply means borrowing securities or assets from someone else to execute a transaction.

In the stock market, you’re usually borrowing from your broker in exchange for interest paid on the securities. You can typically borrow 50 percent of the stock’s purchase price.

However, that’s not required. You might decide to borrow just 5 percent or 10 percent. Buying on margin at lower percentage rates can help you manage your risk tolerance, but remember that there’s always a risk.

You need a margin account to exercise leverage. This is different from a cash account. You’ll usually have a minimum deposit, which starts at $2,000 but can go much higher. Plus, you’ll need to prove certain things to your broker.

Brokerage firms have higher standards for margin accounts because investors will be borrowing from them. You might need to have a certain net worth, for instance.

Leverage Is a High-Risk Strategy

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Businessman standing on unstable coin. Via shutterstock.com

Just like in gambling, investing risk increases with reward. The higher the potential payout, the higher your risk for great losses. This is especially true when you’re trading with leverage because you’re playing with the house’s money, so to speak.

Brokerage firms require margin account holders to maintain a certain minimum balance. Your cash and owned securities serve as collateral for whatever you’ve borrowed, which mitigates risk for the broker. It increases your risk, though, because if you borrow too much on a losing position, your account can get wiped out in a flash.

What is Buying Power With Margin?

To understand margin buying power, you have to understand equity.

For example: Let’s say you bought a house 10 years ago for $200,000. Between your payments toward the principle and your down payment, you’ve now paid $40,000 toward your mortgage. This represents your equity. It’s the amount of money you’ve put into the house as long as the home’s market value holds.

In a margin account, your equity is the amount of cash in your account. Typically, your margin buying power increases with your equity because of the ratios mentioned above.

For example: If you have $100,000 in equity in your margin account, your margin buying power is $200,000 (your equity plus margin at 2:1).

Your margin buying power changes as you execute trades, though. Another example: Let’s say you bought $10,000 worth of shares in a stock, decreasing your equity to $90,000. Your margin buying power shrinks to $180,000 as a result.

What is the Dreaded Margin Call?

The margin call is one of the most disastrous experiences for any investor. It happens when your equity drops below a specific point, and your broker requires you to make up the difference by depositing cash in your account or selling securities.

Many margin accounts have a maintenance margin requirement of between 30 and 40 percent. In other words, you can borrow up to 50 percent, but you have to maintain a 30 or 40 percent margin.

In short, a margin call is an act that forces the investor to either put more cash into his account or liquidate his position.

Margin Call Example

Example time again: Say that you have bought $10,000 worth of shares in a stock, using $5,000 from your broker and $5,000 of your own cash equity. We’ll further say that you have a maintenance margin of 30 through your broker.

The worst happens. The stock you bought drops in price $6,000. You’ve already borrowed $5,000 from your broker, and you have to maintain that 30 percent margin. You only have $1,000 of equity in the position, so you’ll have to deposit enough funds to bring your margin back up.

Risk of Excessive Real Leverage In Forex Trading

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Risk button pointing between low and high level, Vector graphic created by OWN23 – Shutterstock.com

When it comes to leverage, you typically have far more buying power in Forex trading.

Many Forex accounts will let you buy on margin at ratios of up to 50:1. That’s a huge difference from the 2:1 buying power you have when buying stocks.

With a 50:1 margin-based leverage, you only have to put up 2 percent of your own money as equity. The brokerage firm covers the rest.

For instance, if you want to enter a position with $10,000 of your own money at 50:1 leverage, you could gain control of a position worth $500,000.

That might sound extremely attractive, but it comes with more risk. Remember, as your reward increases, so do your potential losses.

When you’re leverage trading in Forex, you MUST resist the urge to buy on margin with a position you can’t comfortably cover.

Notice that I said comfortably. Never invest money you can’t afford to lose.

Why I Don’t Recommend Traders to Use Leverage

Leverage trading is a slippery slope, in my opinion.

When investors become too dependent on their margin accounts, they lose sight of the bigger picture and get more confident in positions where they shouldn’t.

It’s the same reason I don’t gamble. I like to know what my money’s doing in the stock market and to know I don’t owe anyone else if my position goes sideways.

Should You Join My Trading Challenge?

If you want to learn how to trade like I do, apply for my Trading Challenge. It’s a fantastic program that allows you to communicate with other traders, including my millionaire students, to help you learn faster.

Different Situations in Which Traders Can Use Leverage

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There are several situations in which leverage can be used. You should know about them even if you never use them.

Leverage Trading Stocks

I’ve spent much of this article discussing leverage trading in the stock market. You’re borrowing shares of a specific stock from your broker.

If you imagine shares as little slips of paper — kind of like money — the concept becomes more real. You have a pile of 100 slips of paper, but you want 200 of them. You borrow 100 from your broker to increase your position.

But what happens if someone — the stock market — takes away your slips of paper? You’re not just losing your own paper, but your broker’s as well. And you’re responsible for the difference.

Leverage Trading Crypto

The crypto market is a little different. It’s based on the lending market, which allows anyone to borrow cryptocurrency, such as bitcoins or altcoins, from a broker, the exchange itself, or a third party. When you don’t have many coins to start with, leverage trading becomes more attractive.

Like penny stocks, cryptocurrencies are extremely volatile. Their value can shoot up or down without much warning, and if you’re not prepared, you could lose a ton of money.

How Does Leverage Work in Forex?

Forex investing involves exchange rates between two currencies, known as pairs. For instance, you might bet that the exchange rate between two currencies will go in a certain direction, then use leverage trading to increase your position size in the investment.

Since margin buying power increases significantly in the Forex market, you’re more likely to put yourself at risk.

Forex Leverage Example

For example: Let’s say that you want to trade $200,000 of currency. In a 100:1 leverage ratio, you’d have to use $2,000 of your own equity to secure the position, while the other $198,000 would come from your broker.

The Bottom Line

Leverage trading is a dangerous game. Buying on margin can put your entire trading account at risk, especially if you’re trading too much of your total net worth.

I don’t recommend buying on margin, but some people swear by it. They enjoy the rush, have greater risk tolerances, and can sometimes profit by huge percentages.

That doesn’t mean you should try it, but you should know that it exists.

Do you use leverage trading? Why or why not?

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