- In the stock market, stock leverage trading involves borrowing capital from a broker to increase position size.
- Traders use leverage to make more money, but there is a serious risk. Learn more in this post.
- You don’t need leverage to grow a trading account. Look what I have done in more than 20 years of trading.
full disclosure: I’m not a fan of using stock leverage. I don’t like buying on margin, and neither do most of my top trading students. but you need to understand leverage trading to trade smarter.
The idea behind leverage trading is to increase your potential reward. the big problem? it doesn’t always work. and it can be dangerous for your trading account, especially when you are new to the stock market.
I prefer to keep things simple. I buy, sell, and sometimes short stocks, mostly penny stocks, for short-term gains.
but too many traders don’t know how to buy stocks with leverage or don’t understand how to buy on margin. Conclusion: I caution against using leverage or trading on margin.
Read on to learn what stock leverage is, how leveraged stock trading works, and why it’s not the best idea.
what is leverage in the stock market?
In the stock market, stock leverage trading involves borrowing stock from your broker to increase your position size. it is so you can earn more money.
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 are essentially financing your position in the stock.
It’s like buying a car. Say you want a new SUV and talk to the salesperson for up to $30,000. You don’t have $30,000 in cash, so you put down $2,000 and finance $28,000 over five years…
Each month, you make a payment, which includes principal (the amount you financed) and interest (the money you pay the lender for financing you).
People do this every day with cars and other physical assets, so it doesn’t seem dangerous. But even buying a car can cause financial problems.
Suppose you put a $2,000 down payment on your new car and pull it off the lot. three days later, you add him up in an at-fault accident. The insurance company pays the market value of the car, which has already depreciated below what you paid for it. you’re stuck paying for the car even though you don’t have it.
That’s what often goes wrong with leverage in stock trading.
how does stock leverage work?
Stock leverage trading works by allowing you to borrow shares of a stock from your broker.
Let’s say you have $1,000 to invest. You could invest in 10 shares of company X stock trading at $100 per share. But to increase leverage, you could invest the $1,000 in five option contracts. then it would control 500 actions instead of just 10.
Similarly, you could use margin buying to increase your leverage. Instead of investing in option contracts, you buy a certain number of shares.
When you exit your position, you have to make a deal with your broker. You are responsible for returning the shares you borrowed to the broker. What remains is your profit, less your initial investment.
what is the leverage ratio?
Leverage ratio is the amount of shares or dollars your broker is willing to lend you, compared to your own capital.
Leverage is always expressed as a ratio, such as 2:1. in that case, you could double your position size by borrowing twice as much as you actually buy.
let’s see an example…
example of 2:1 stock leverage
If you have 2:1 leverage, that means you can borrow twice 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 with a 2:1 margin. then you would have $100,000 to invest.
however, it’s not free. You have to make an initial deposit or initial payment to your broker for the privilege of buying on margin. It’s kind of like the example of buying a car from earlier. this is how brokers make money by spreading the margin.
but what about your investment?
Let’s say you buy $100,000 worth of stock at $100 per share. the stock rises to $103 and you sell.
at that time, you must return the borrowed shares or money to your broker. The brokerage firm put out $50,000, so you have to pay it back, plus interest. the rest you keep as profit.
But if the stock price falls and you lose money, you still have to pay your broker back. and it has to cover any loss you and your broker incurred during the trade.
stock leverage example 10:1
The same rules apply if you use more leverage. Let’s say you use 10:1 leverage…
some traders want to use leverage when they have a small account. they think they can grow it faster that way by taking bigger positions.
but this can be risky.
Let’s say your account is $500 and your broker gives you a margin to trade. In this example, the share you want to buy is $5; could buy 100 shares. but you think there is only a 20-cent advantage in the trade. so you decide to use leverage to try to increase your profits…
You buy 1,000 shares at $5 for a total of $5,000. if the trade works, you can make a profit of $200 instead of $20.
but let’s say the trade doesn’t pan out… or hits its target but falls too fast for you to walk away with a profit. then the action continues below his entrance before he can react.
When it comes out, it has lost 20 cents a share. so for your $5,000 position, you get $4,800. but you also owe your broker the money he borrowed. so they get their $4,500 back plus fees and interest. and you just lost $200 instead of the $20 you would have lost if you had used your own funds.
These actions can move so fast. you could end up losing a lot more than you anticipate. That’s why I always say…
leverage is a high risk strategy
Just like in gambling, risk increases with reward. The higher the potential payout, the higher your risk for great losses. That’s especially true when you’re trading with leverage — you’re playing with the house’s money, so to speak.
Brokerage firms require margin account holders to maintain a certain minimum balance. Your own cash and securities serve as collateral for whatever you’ve borrowed, mitigating risk for the broker.
but it increases your risk. if you borrow too much in a losing position, your account can be gone in an instant.
or ignore my lessons & try to trade big with no rules/experience & you will learn the hard way why I teach what I teach. then, you can listen to me or learn in a much more expensive/confusing way with the market as your teacher, you choose & Realize that experience is the key!
— timothy sykes (@timothysykes) June 15, 2020
what is the maximum leverage in the stock market?
Maximum leverage is the largest position you can take based on your margin amount. Margin requirements vary by market.
Most brokers will only allow you to borrow 50% of the value of your position to trade stocks with leverage.
forex or futures trading may have a higher allowable margin. so the maximum leverage can be quite high. with forex, it could be up to 400 times. that means small fluctuations in the market can cause you to clear your account much faster.
what are the most common types of leverage?
Leverage refers to borrowing funds to invest.
businesses or companies can use leverage to buy assets or invest in product development. they can do that instead of offering more shares to raise money.
Some of these companies can become highly leveraged: they have high debt and are risky investments. that is something to consider when doing fundamental analysis.
In trading, the most common type of leverage is margin. margin is a type of debt. it is the amount your broker is willing to lend you to invest. once you use it, you’re using leverage.
buy on margin
Buying on margin simply means borrowing securities or assets from someone else to execute a trade.
In the stock market, you typically borrow from your broker in exchange for the interest paid on the securities. you can typically borrow 50% of the purchase price of the shares.
but that’s not required. You can decide to borrow only 5% or 10%. Buying on margin at lower percentage rates can help you manage your risk tolerance…but remember there is always risk.
You need a margin account to exercise leverage. this is different from a cash account. Usually you will have a minimum deposit, which starts at $2,000 but can be much higher. In addition, you will need to prove certain things to your broker.
brokerage firms have higher standards for margin accounts, like a certain net worth, for example.
what is purchasing power on margin?
To understand the buying power of margin, you need to understand equity.
here is an example…
Let’s say you bought a house 10 years ago for $200,000. Between her principal payments and his down payment, she has now paid $40,000 toward his mortgage. this represents her fairness. is the amount of money she invested in the house as long as the market value of the house remains.
In a margin account, your equity is the amount of cash in your account. Generally, your margin buying power increases with your equity.
So, if you have $100,000 in equity in your margin account, your margin buying power could be $200,000 (your equity plus margin at 2:1).
however, your margin buying power changes as you execute trades. Here’s another example: Let’s say you buy $10,000 worth of stock in one stock, decreasing your equity to $90,000. As a result, your margin buying power is reduced to $180,000.
what is the dreaded margin call?
The margin call is one of the most disastrous experiences for any trader or investor. It occurs when your equity falls below a specific point and your broker requires you to make up the difference by depositing cash into your account. account or selling securities.
Many margin accounts have a maintenance margin requirement of between 30% and 40%. In other words, you can borrow up to 50% percent, but you must maintain a 30% or 40% margin.
In short, margin calls force traders to put more cash in their accounts or liquidate their positions.
margin call example
Again as an example: Let’s say you buy $10,000 worth of stock using $5,000 from your broker and $5,000 of your own cash. you also have a 30% maintenance margin through your broker.
then, the worst happens. your position falls by $6,000. You’ve already borrowed $5,000 from your broker and must maintain that 30% margin. You only have $1,000 of equity in the position, so you will need to deposit enough funds to get your margin back.
different situations where traders can use leverage
There are several situations where leverage traders can use leverage. you should know about them even if you never use them.
take advantage of commercial actions
I devoted much of this article to discussing leverage trading in the stock market. you are borrowing shares of a specific stock from your broker.
If you think of stocks as little pieces of paper, something like money, the concept becomes more real. he has a stack of 100 sheets of paper, but he wants 200. so he borrows 100 from his broker to increase his position.
but what happens if someone (the stock market) takes away your sheets of paper? You are not only losing your own paper, but also your broker’s. and you are responsible for the difference.
leverage cryptocurrency trading
The cryptocurrency market is a bit different. It is based on the loan market. which allows anyone to borrow cryptocurrencies, 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.
Just like penny stocks, cryptocurrencies are extremely volatile. its value can shoot up or down without much warning. If you’re not prepared, you could lose a lot of money.
how does leverage work in forex?
Forex trading involves exchange rates between two currencies, known as pairs. For example, you can bet that the exchange rate between two currencies will go in a certain direction, and then use leverage to increase your position size.
Since the purchasing power of margin increases significantly in the forex market, you are more likely to put yourself at risk…
forex leverage example
Let’s say you want to trade $200,000 in foreign exchange. At a 100:1 leverage ratio, you would use $2,000 of your own capital to secure the position, while the other $198,000 would come from your broker.
now imagine that the operation goes wrong and you have to pay that amount to your broker…
how to trade stocks with leverage
Personally, I don’t think you should trade stocks with leverage. I’ve made over $7.3 million trading penny stocks. And I started with a small account. More on that in a bit…
If you insist on risking yourself and your trading account, you first need a margin account to trade stocks with leverage.
Once you have a margin account, you can take a position using your funds plus your margin.
Did I mention it’s risky? no exchange is 100% guaranteed. you always run the risk of losing money that is not yours.
Even if you have a few wins, you can learn the wrong lessons, become overconfident and take bigger risks. that can result in higher losses when using leverage.
risk of excessive real leverage in forex trading
With leverage, you typically have more buying power in forex trading.
Many forex accounts allow you to buy on margin in ratios up to 50:1. that’s a big difference from 2:1 buying power to buy stocks.
With 50:1 margin-based leverage, you only put up 2% of your own money as equity. the brokerage covers the rest.
For example, if you wanted 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 may sound appealing, but it comes with more risk. Remember, as your reward increases, so do your potential losses.
Resist the urge to buy on margin with a position you can’t comfortably cover. never invest money you can’t afford to lose.
& how to trade with a small account only evaluate your positions after you have perfected the trade with small size, don’t be greedy & trade big right away
— timothy sykes (@timothysykes) June 15, 2020
should i use leverage on stocks?
not. In my opinion, leverage trading is a slippery slope.
When investors become too reliant on margin accounts, they lose sight of the big picture. they gain more confidence in positions where they shouldn’t.
It’s the same reason I don’t play. I like to know what my money is doing in the stock market. I want to know that I don’t owe anyone else if my position deviates. That’s why I trade small and conservative, cut losses quickly and take simple.
I have been trading for over 20 years. and although the market changes, my patterns largely remain the same.
focus on rules and process. learn how stocks move and why. take the time to build your knowledge account and you can slowly build your money account. it takes time. my best students like jack kellogg, matthew monaco and kyle williams took a few years to learn the process.
but in a dynamic market, that discipline is key. take a look:
I never recommend that new traders use margin. You should never risk more than you can afford to lose. And when it comes to using margin, you’re using someone else’s money.
should you join my trading challenge?
my trading challenge is not for everyone. it is only for the most dedicated students. That’s why I get people to apply. I don’t accept everyone.
but if you want to learn how to trade like me, apply today. In the challenge, you get access to live trading sessions, all my DVD and video lessons, plus hang out with the best traders in the best chat room ever.
Not up for the challenge? start with some of my other resources, like the thousands of videos i’ve posted on youtube. there’s my free guide to penny stocks. or my book on how I started trading, “An American Hedge Fund” – you can get a copy free of charge.
There’s also “The Complete Penny Stock Course” by my student Jamil. review my complete strategy.
Also check out my free “Volatility Survival Guide” and my new supernova alerts. there are so many ways to learn. it’s up to you to commit.
stock leverage: the bottom line
Leverage trading is a dangerous game. Buying on margin can put your entire trading account at risk, especially if you are trading too much of your total net worth.
I don’t recommend buying on margin, but some people swear by it.
Maybe they want to go bankrupt on a bad deal. people like all kinds of weird things…
I don’t think anyone who wants to be a smart, self-sufficient trader should try it. but it’s good to know what it is and who might use it.
Do you use leverage trading stocks? why or why not? let me know in the comment.