For stock traders, one of the not-so-secret tools they can utilize is leverage, which is their capacity to borrow funds from a broker to boost the purchasing power they currently possess.
For relatively new traders, it is best to understand first the benefits and potential pitfalls of this type of investing before being seduced by its promise of great return.
Leverage in stock trading includes borrowing money to raise the number of shares involved in a deal beyond the amount a trader is initially willing to purchase with cash from their own pocket. It works by increasing the exposure to underlying asset by means of a deposit, which is also known as a margin, to secure the borrowed funds.
Particularly for traders with limited capital, leveraged trading is a powerful tool that can help investors in maximizing returns on even the smallest price changes, growing their capital exponentially and increasing their exposure in desired markets.
Leverage can be used when buying on margin, as previously mentioned, or when purchasing futures and options. It can also be used for exchange traded funds that employ leverage to alter their performance and for trading derivatives.
Simply put, leverage in the stock market can increase the return of investment whenever the price of stocks goes up (when buying). At the same time, it could also increase the loss if the alternative happens. For example, if a trader buys a $100 stock using $50 from his own pocket and $50 using leverage, a price increase to $150 for the stock would mean a 100% return for the trader (after selling the stock and returning the borrowed funds). However, if the price falls to $50, instead of only losing $50 if the trader bought using only cash on hand, he would lose 100% if leverage is used.
One of the benefits of using leverage when trading on the stock market is that it can come with no interest or commission obligations even though it is still a borrowing. This gives the trader the freedom to utilize the "loan" in any way when trading.
Another good thing about leveraged trading is that it increases the amount of money that a trader can use for investment in different markets. Leveraged traders can also boost their profits from profitable trades and have access to investments that would have been too expensive or prestigious when targeted using only cash on hand.