Leverage: Its Meaning, Pros, Cons, and How It Works in the Stock Market

What is the definition of leverage?

In physics, leverage is a mechanical advantage that magnifies a small input force to create a larger output. The same logic applies to financial leverage, an investment strategy of utilizing borrowed capital to amplify the potential return on investments. It also increases an investor’s purchasing power in the stock market.

Leveraged trading is a type of trading that uses borrowed money to trade and make profit. The use of borrowed funds to generate a significantly bigger potential return on your investment is referred to as leverage trading, and it’s also called Margin Trading. It enables you to take on greater positions than your initial money would allow.

The objective is to borrow money to buy additional shares of an asset in the hopes that the profits on the position would outweigh the cost of borrowing.

How Does Leverage Work in the Stock Market?

For better understanding, let’s discuss this concept with an easy example.

Let’s take Reliance stock as an example. Currently, Reliance is trading at a stock price of Rs. 2819. If a trader decides to do intraday trading on this stock in the equity segment, he can do that in two ways:

1. Leveraged Trading
2. Non-Leveraged Trading

Assume that a trader has a capital of Rs. 2 lakhs. With this capital, if he decides to do non-leveraged trading, he can buy or sell only 70 shares of Reliance. Now, let’s assume that he bought 70 shares of Reliance for Rs. 2819 and sold them at Rs. 2833, his profit would be 70*(selling price – buying price) = 70*(2833-2819)= Rs. 980.

Now, let’s understand how leveraged trading works. Usually, the amount of leverage offered by stockbrokers varies from one to another. But let’s go with 5 times leverage. That means your stockbroker is offering 5 times leverage, and with this, you can buy 5*70 = 350 shares of Reliance instead of 70 shares with non-leveraged trading. Since you are buying 5 times more with the same amount, your profit and loss also will be 5 times more.

Again assume that the selling price was Rs. 2833 and buying price was Rs. 2819. The profit in leveraged trading would be the Number of shares bought (Selling Price – Buying Price) = 350 * (2833 – 2819) = Rs. 5180 (5 times more than non-leveraged trading profit).

Advantages

1. It increases your purchasing power, allowing you to acquire more units at a fraction of the price.
2. It allows stock traders to make a greater profit on each trade.

Drawbacks:

1. It increases risk exposure.
2. Losses incurred while leverage trading are far greater than losses incurred if you did not trade on leverage at all.

Conclusion

In the stock market, leverage is simply a way to boost the rewards of your trade. Nevertheless, like everything else in trading and finance, it comes with some risks. You can benefit if you are an experienced trader and balance your moves. There’s always the risk of being over-leveraged, so remember that it might swiftly deplete your account if something goes wrong. Hence, keep track of your positions, use the stop-loss option, and don’t get too excited.