What is Leverage Trading?

Of late, the use of leverage in trading has increased significantly. Leverage trading is a powerful financial strategy that enables traders to enter large positions with just a small amount of capital. The strategy involves using funds borrowed from the stockbroker and can amplify the profits from a trade. This makes it a highly attractive option for traders looking to maximise their returns.

However, while leverage trading can be beneficial when used right, it could also lead to major losses if the market moves unexpectedly. If you plan to use leverage when trading, understanding its fundamentals, its benefits, and its drawbacks is crucial. In this comprehensive guide, we will extensively explore the concept of leverage trading using an example to help you understand just how it works.

Leverage Trading Meaning

Also known as margin trading, leverage trading is a facility that stockbrokers offer to traders. Traders who use this facility essentially borrow funds from a stockbroker and use it to take up positions in an asset.

To use this facility, however, traders must deposit a small amount of capital upfront, known as the initial margin. This initial margin acts as collateral for the borrowed funds and is usually a fraction of the total trade value.

The amount of leverage on offer tends to vary depending on the stockbroker. Most stockbrokers in India offer a 4:1 (4X) leverage, meaning traders can take up a position worth four times more than what they deposit. For example, let us say that a trader deposits ₹1,000 as the initial margin. If the stockbroker provides a 4:1 (4X) leverage, they can control a position worth ₹4,000.

Now, in exchange for allowing traders to trade on margin, the stockbroker will levy interest on a per-day basis on the borrowed amount. Furthermore, as an additional security measure, the shares that the traders purchase on margin will also be pledged to protect the broker from default and losses due to unexpected market movements.

Sometimes, the value of the shares purchased on margin may drop due to unfavourable market movements. In such cases, the stockbroker may require leverage traders to deposit additional margin, known as maintenance margin, to continue holding onto their positions. If the maintenance margin is not deposited on time, the positions will be closed automatically by the broker and their dues will be recovered.

How Leverage Trading Works? A Comprehensive Example

As a beginner, the concept of leverage trading might seem complicated at first glance. Let us break it down and make it easier to understand with the help of a hypothetical example.

Imagine a trader who wants to buy 1,000 shares of a company, whose share price is ₹80. The total value of the trade would be worth ₹80,000, but the trader only has ₹20,000 in his trading account. To make this possible, they opt to trade on margin. The stockbroker offers leverage at a ratio of 4:1 (4X), providing the trader with the remaining ₹60,000 (₹80,000 – ₹20,000). In exchange, the broker charges interest at 0.05% per day on the borrowed funds of ₹60,000.

Now, let us consider two scenarios: one where the share price rises and one where it falls to understand what would happen.

• Scenario 1: Profit 

Assume the share price of the company rises to ₹100 after 5 days. At this point, the trader decides to realise the profit and sells the 1,000 shares he owns. The gross profit from the trade would be:

Gross Profit = [(1,000 shares x ₹100) – (1,000 shares x ₹80)]

Gross Profit = ₹20,000

As you have already seen, the stockbroker levies interest on the borrowed funds. This interest, along with other trading-related charges, must be accounted for to arrive at the net profit.

Interest = [(₹60,000 x 0.05%) x 5 days]

Interest = ₹150

Assuming the trading-related charges come up to another ₹150, the net profit from the trade would be as follows:

Net Profit = (Gross Profit – Interest – Trading Charges)

Net Profit = (₹20,000 – ₹150 – ₹150)

Net Profit = ₹19,700

The use of leverage enabled the trader to make a profit of ₹19,700. Had they only used their capital to trade, they would have only been able to purchase 250 shares, giving them a profit of ₹4,850 [(250 shares x ₹20) – ₹150].

• Scenario 2: Loss 

Now, let us assume that the share price falls to ₹65 after 5 days. Since the value has dropped significantly, the stockbroker raises a maintenance margin call asking the trader to deposit additional funds to keep the position active. At this point, the trader can deposit the maintenance margin and continue to hold on to the position.

However, the trader decides to exit their position. The loss from the trade would be:

Loss = [(1,000 shares x ₹65) – (1,000 shares x ₹80)]

Loss = (₹15,000)

Accounting for the interest (₹150) and trading-related charges (₹150), the net loss from the trade would be as follows:

Net Loss = (Loss + Interest + Trading Charges)

Net Loss = (₹15,000 + ₹150 + ₹150)

Net Loss = (₹15,300)

As you can see, the use of leverage also amplified the losses. Had the trader not used leverage to trade, they would have only been able to purchase 250 shares, giving them a loss of ₹3,600 [(250 shares x ₹15) – ₹150].

Advantages of Leverage Trading 

Leverage trading offers several benefits, making it a popular choice for traders. Here is a quick overview of some of its key advantages.

• Increased Position Size

Margin trading allows traders to control larger positions with less capital. With the facility, traders can get access to high-value trades that might otherwise be out of reach.

• Profit Potential

Due to the increased position size, margin traders might generate more returns from their trade. In fact, even small price movements can lead to substantial returns due to the amplified exposure.

• Ability to Capitalise on Opportunities

Many opportunities in the stock market are short-lived. With leverage, traders can quickly capitalise on short-term market opportunities and daily price fluctuations without the need to wait for funds.

Disadvantages of Leverage Trading 

While margin trading offers the potential for amplified returns, it also comes with its own set of challenges and risks. Let us look at some of the key drawbacks of this facility.

• Higher Risk of Losses

Although leverage significantly increases profit potential, it also magnifies losses. In some extreme cases, the losses can far exceed the initial margin deposited at the time of initiating the trade.

• Margin Calls 

Stockbrokers require traders to maintain a certain level of margin at all times. Falling below the specified threshold triggers a maintenance margin call. If traders do not meet the call on time, stockbrokers could liquidate the position and sell the pledged shares to recover dues.

• Interest Costs

Borrowing funds for leverage from the stockbroker incurs interest. The interest can add to the overall cost of trading and reduce profits or increase losses.

• Overleveraging 

The easy access to leverage can lead to traders entering large positions frequently, disregarding proper risk management. This can lead to overtrading and losses, especially if the market does not move as expected.

Conclusion

With this, you must now be aware of leverage trading and its various benefits and risks. Now, it is important to understand that trading on margin is a double-edged sword that can offer significant profits while exposing traders to higher risks.

As a trader, if you plan to use leverage trading to maximise the profit potential, you must exercise caution. Consider adopting disciplined trading practices and employing robust risk management strategies to ensure that you do not incur losses.

Disclaimer: Investments in the securities market are subject to market risks, read all the related documents carefully before investing. This is for educational purposes only. The securities are quoted as an example and not as a recommendation.

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