Trading stocks can be a great way to earn some extra money, provided that you have the necessary knowledge, experience, and tools. However, for professional traders, it may not be enough anymore.
At some point, traders might find regular stock trading monotonous and not profitable enough. Meanwhile, traders who wish to earn more but do not have, or don't wish to risk great amounts of money also run into a similar problem.
Fortunately, there is an easy solution for both of these groups, and it lies in trading stocks with leverage.
Leverage lets you earn more with only a chunk of the profits that you would usually need. However, it has its downsides, as well. If you wish to learn more about it and try it out for yourself, just keep reading, and we will share everything you should know about trading stocks with leverage.
What are leverage and leveraged trading?
Let's start from the beginning, and answer the question — what is leverage?
Leverage is a trading mechanism that any trader can use on platforms that allow it. Leverage is used to increase the trader's exposure to the market in a specific way.
Simply put, a trader can pay less than the full amount of the investment. As a result, they get to take a greater position without having to pay the full price of it. It is a process that revolves around taking a type of credit provided by the broker, and only paying a percentage of the full transaction.
In other words, you deposit a small amount of cash, and borrow a bigger amount. So, for example, a trader who wants to trade at a value of $100,000 can only deposit $1,000, and have the broker provide the remaining amount. In order to receive this amount, the trader has to leverage at 100:1, which increases the reward, but also the risk of losing their entire investment if they make a mistake.
To make this even simpler, let's say that the trader still wants to invest $100,000, but they only have $50,000. They can use leverage to buy on margin at 2:1, which would allow them to invest $100,000.
This will, of course, depend on the trader's plan, the size of their deposit, the broker's offer, and many similar factors, and we only use it here as an example.
Now, apart from leverage itself, there are several other terms that anyone who wishes to trade with leverage should know. Those include things like:
- Buying power, which is the amount that a trader has available, including leverage.
- Risk ratio, which is an indicator that represents the ratio of the net account balance, in relation to the amount that is leveraged.
- Margin call, which is a warning that the broker issues to the investor if the investor's exposure is too big, and represents a risk that exceeds levels that the broker is comfortable with. It is also considered one of the most disastrous experiences for traders and investors.
- Closing position, which is when the broker starts canceling the clients' pending orders due to a margin call.
Mind the risk
As you likely know, most people who deal with stocks rarely trade them. Stocks are usually seen as the best asset for long-term investment. Of course, this is neither a rule nor the law, and you can, in fact, day-trade stocks if you want to do it.
With that said, it should also be noted that there are assets with greater potential for day trading on their own, such as forex, cryptocurrencies, and alike. Stocks are the best type of investment for those who wish to invest and forget about that money for a while. Then, after a few years, or even decades, they return and sell their stocks for a huge profit, provided that they invested in the right firm.
But, if you wish to day-trade, that is when leverage comes into play, and when it is quite useful. It can be applied for longer trades, of course, sometimes measured in weeks, or even months. Even so, we need to underline the fact that leveraged trading comes with quite a high risk, and the risk grows bigger and bigger with the leverage, as well as the amount that you use for trading.
Despite this, trading stocks with leverage has become quite an attractive option for investors. This is, of course, no coincidence. Leveraged trading allows you to massively increase your potential returns. The unfortunate fact is that it, due to its nature, mostly attracts traders with little capital, and often even less knowledge.
People are attracted by the opportunity associated with leveraged markets, and the potential to become much wealthier by the end of the day. This causes them to dismiss the risks, which ultimately leads to major losses.
If you were to go to Google and search leveraged trading, you would see an overwhelming number of websites offering just that. There are no barriers for entry, and you can start doing it regardless if you have a decade of experience, or only an hour.
This is why it is important to understand that your success depends on your knowledge, experience, and information.
How to trade with leverage correctly?
One reason why trading with leverage is considered so risky is that people tend to use it in the wrong way. Traders often enter the market with a certain amount — let's say $10,000. Then, they trade with leverage with the goal of making a major profit by investing all of it, and more, into a single company's shares.
This is a very risky move, which could result either in major earnings, or a complete failure, where you lost your own money, as well as your broker's. Not to mention that this is far from being the right way of going about it.
So, how do you use leverage correctly and efficiently?
The answer is rather simple — change the way you view leveraged trading.
Leverage, like anything else in the trading world, is a tool that can and should be used. In fact, it can be extremely efficient, as it allows you to use your trading capital with greater efficiency. This is how professional traders do it, as it allows them to take larger positions with less trading capital.
In other words, leverage is not there to alter the potential profit or losses. Rather, the best way of using it is to reduce the amount of capital that you need to use. As a result, you are left with more capital for your other trades. The key is to distribute your capital and invest in as many different shares as you can, while still making trades profitable.
So, if you had $20,000 for investing, and you wanted to buy 1,000 shares of stock at $20 per share, you would need maybe $5,000 of your own money, and the rest can come through leveraged trading. That leaves you with an additional $15,000 of your own money for other trades.
That way, even if one of your trades were to fail, you could still succeed at others, and make a major profit that would cover the loss of that one failed trade.
Naturally, the risk is still there. But, the more diverse your portfolio is, the bigger the chances that you will see gains, rather than losses, overall.
Every trade comes with the amount of risk, that much is not being questioned. But, once you have enough experience, you will be able to handle greater amounts of risk, and gain bigger rewards when your trades end up being successful. This is why leveraged trading is mostly recommended for traders who are accustomed to risk.
Advantages and disadvantages of leveraged trading
So, we have stated earlier that leveraged trading has its advantages, as well as its flaws. Let's summarize everything said so far in two sections.
Pros of trading with leverage
As mentioned, the biggest advantage of leveraged trading is the fact that it provides you with access to additional funds for trading. This allows you to diversify your portfolio, and still gain more exposure to the market.
The alternative would be to either invest your entire capital into a single trade, or to trade at small amounts and risk losses, without having the chance to earn enough to be worth it.
Another advantage of leveraged trading is the fact that it opens up a new section of the market for you. This is something that we did not talk about so far, but it is still a very real advantage.
As you may know, some trading instruments are relatively cheap. As such, they are available to the majority of traders. However, there are also some that are considered premium, and as such, they have a significantly higher price.
Naturally, this often means that some traders won't be able to buy such instruments, simply due to their limited capital, or trading strategy. Fortunately, they don't have to be excluded from such trades if they are willing to trade with leverage.
Disadvantages of leveraged trading
Of course, every coin comes with two sides, and with that in mind, let's discuss the flaws of trading with leverage.
Throughout this text, we made a point to stress how risky it can be to use leverage if you don't know what you are doing, or you take the wrong approach.
Coming into leveraged trading without proper knowledge, and especially without protections such as stop-loss and similar risk management tools can only lead to large losses and even a margin call.
The disadvantages may not be too great in number, but you will definitely feel them if you do not enter your trades prepared, and with adequate plans for handling various situations. This is why we always recommend educating yourself and gathering experience before you move on to advanced forms of trading, such as trading with leverage.
What is the reality of trading with leverage?
In the end, we should note that trading with leverage is not for everyone. In fact, it is likely not the right approach for the majority of people, considering the fact that 90% of those who try tend to end up broke, or break even, in the best-case scenario.
This is the reality of the situation, and while it may not be an encouraging thing to hear, it is the truth. Even so, a lot of people will choose to ignore it, as they know someone who got lucky or who has enough experience to make it work, and so they will try it out themselves. That is fine, but remember — statistics do not lie, and getting rich quick is not really a thing in the real world.
Because of it all, most people are advised not to use leverage in stocks. It is simply a slippery slope, and investors tend to become too dependent on margin accounts. This often leads to getting more confident when they really should not be, and they start gambling instead of trading.
So, if you are planning to try leveraged trading anyway, the best advice we can give is to not take chances, don't gamble, and know what you did and why you did it. If you are still learning how to trade stocks efficiently, we advise that you rely on signals, trade small, cut your losses quickly, and to find a strategy that works for you, and then stick to it.
Trading stocks with leverage can be an excellent way of making a profit if you do it correctly. The best way to go about it is to use smaller amounts of your own money, and make up for it by borrowing from your broker. Meanwhile, use the remaining funds to diversify your portfolio, and increase your chances of success.
Keep track of the market at all times, follow the current events, watch for signals, and don't take chances. Do this, and you should have at your disposal all the tools you need to become a successful trader. There is no guarantee of it, of course, even then. But, your chances of becoming one will be significantly improved, and that's already a pretty good start.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a master's degree in finance and writes extensively about the financial markets and fin-tech industries.