How Leverage Works in Trading

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Leverage does not only work in an online casino where you bet without risk, and yet you win real cash. Leverage also works in trading—but how?

We will show you how it works, but we have to warn you that it has associated risks. In addition, you must find an institution that will allow you to trade on leverage—you cannot expect this from all platforms or financial institutions.

What is Leverage Trading?

Leverage trading is one where you borrow money from someone to buy shares. People do this because they are short on cash, but they believe that the fluctuations of the stock price can make them money, giving them a profit on top of what they borrowed.

There are different ways to trade on leverage, but all of these boil down to one thing: the investor does not have enough capital to buy the shares he wants to own.

Trading on Margin

Trading on margin is one type of leverage. Here, you borrow money from a broker to buy the shares you want. Typically, you must have collateral to get this loan, like other stocks that you already own.

Here is an example:

  • You have $100,000 in your stock market account.
  • You want to buy stocks of ABC Company, which is trading at $50 per share.
  • With your cash, you can buy 2,000 shares only.
  • Now, what if you want to buy 4,000 shares?
  • To do this, you can borrow $100,000 from your broker. So, you do this.
  • You now have $0, but you have 4,000 shares of ABC Company, and you owe $100,000. 

Let us say that the price of ABC Company goes up to $60 per share. If you sell all 4,000 shares, your total cash will be $240,000. Your capital is $200,000, so you made a profit of $40,000. After paying your debt of $100,000, you still have $140,000 left.

Of course, this looks good on paper. However, there is a risk. What if the price of ABC Company goes down to $30? Then, the time comes when you have to pay your broker what you owe. At this point, your 4,000 shares are only worth $120,000. You must pay your broker $100,000. Now, you only have $20,000 left. You invested $100,000 from your cash, so you lost $80,000 in the process. 

 

Short Selling

A variation of this is short selling. Here, you borrow stocks from your broker because you believe the price will go down.

Here is the process of short selling:

  • You borrow 1,000 shares of Stock A, which is now trading at $10 per share.
  • You sell all of that now, which gives you cash of $10,000.
  • The price of the stock goes down to $8 after a week.
  • You buy 1,000 shares at $8 per share, spending $8,000, and then you return those shares to the broker.
  • You still have $2,000 left from your original $10,000. Thus, you make a profit.

Short selling is not always allowed in all stock markets. In addition, this approach can turn horrible. If the price of Stock A rises to $15, you will need to buy back the 1,000 shares at $15,000 to give it back to the broker. Since you only have $10,000, you will  lose $5,000 in the process.

People also apply this to trading commodities. For example, you believe that the price of corn will go down in the future. So, what you do is borrow a contract for 1,000 tons of corn at a price of $15. You promise the broker that you will give 1,000 tons of corn 60 days from now.

Right now, you have no money. What you have is 1,000 tons of corn. It is selling now at $15. So, you sell that for 1,000 tons for $15,000. Sixty days from now, the price of corn is at $10. You must buy 1,000 tons of corn for $10,000, and then give it back to the broker. Since you sold it for $15,000, you have a profit of $5,000.

Derivatives aka Options

The other method to trade with leverage is through the use of derivatives, which people call “options.” An options contract means you have control over the shares, but you pay less than the stock’s actual price. In a sell call option, you are selling the right to someone else to buy shares at an agreed price at agreed expiry date.

Here is an example:

You believe that ABC Company will lose value. Instead of buying the shares, you decide to sell call options. You say that the strike price is $40. What it means is that you have the right to buy 100 shares of this stock at $40. Since you are the holder, you have the right to buy these shares at a set price. However, it is not an obligation.

If the price of this share is above $40, say, $41, the option holder can force you to buy the shares and give the shares to them. So, for 100 shares, you buy the shares for $4,100. If the price goes down, you win. If it goes up, you lose.

Summary

Leverage trading is a risky business, but then, it also provides you with an opportunity to make a killing. People who do this should have the same mindset as professional gamblers—you should not invest money that you are not prepared to lose.

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