Introduction:
When you think of borrowing, you may automatically think of loans and credit cards. But beyond consumer debt, there is another type of borrowing in the stock market called leverage. If used correctly, this powerful strategy can offer you better flexibility to invest and potentially amplify your gains. Understanding how leverage works is crucial for prudent investing. Let us explore leverage, how it operates, and how you can use it to make informed decisions in the stock market.
What is leverage in the stock market?
Leverage in the stock market involves borrowing money to trade securities. Also known as margin trading, this concept entails using a deposit, referred to as the margin, to increase exposure to the underlying asset. Leverage allows you to engage in transactions with a higher value than you can afford outright. You only need to put down a fraction of the total trade value. You can borrow the remaining amount from your provider.
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Let's say you decide to invest in ABC company's stock, which is priced at Rs 200. Without leverage, if the stock price rises to Rs 250, you would earn a 25% return on your investment. However, if you choose to use leverage by putting down Rs 100 of your own money and borrowing the rest, your total investment becomes Rs 200. If the stock price rises to Rs 250, your return is 50%, thanks to the amplified investment made possible through leverage.
It is essential to understand that leverage amplifies both potential gains and losses. This makes it a powerful but risky strategy in stock market investing.
For example, imagine you invest in ABC company's stock, valued at Rs 150, without using leverage. If the stock price drops to Rs 100, you incur a 33.33% loss on your initial investment. However, if you opt for leverage and put down Rs 75 of your own money while borrowing the remaining, your total investment is Rs 150. In this scenario, if the stock price declines to Rs 100, your loss is now 50%. In this case, leverage magnifies your losses.
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Benefits of using leverage
- Possibility to make higher investments: One significant benefit of using leverage is the ability to increase the amount of money accessible for investment.
- Availability across various markets: Leveraging is not limited to a specific market. It is widely available in multiple financial markets, like indices, forex, or cryptocurrencies. This flexibility allows you to apply this strategy across different asset classes.
- No interest or commissions: Unlike traditional borrowing, leveraging does not charge interest or commission. This makes it a cost-effective strategy to maximize your investment potential without incurring additional financial burdens.
- Trading expensive assets: Leverage allows you to trade in expensive, prestigious assets that might otherwise be out of your reach.
- Better diversification: Leverage is a valuable tool for diversifying your investment portfolio without allocating significant capital. With leverage, your money is not tied up in multiple assets, yet at the same time, it is spread across various markets and instruments.
Things to keep in mind when using leverage
- Eligibility of stocks: It is essential to be aware that not every stock in the market is eligible for leveraged trading. The Securities and Exchange Board of India (SEBI) maintains a specific list of stocks approved for leverage.
- Minimum balance: Brokerage firms often require you to maintain a minimum balance before you can ask for leverage. You must adhere to this requirement to be eligible to use margin trading.
- Leverage ratios: Leverage is commonly expressed in terms of a ratio, such as 2:1. Understanding these ratios is essential for making informed decisions about your borrowing limit.
- Risk management: Leverage trading is inherently risky as it can amplify losses. One way to limit your losses is by setting up stop-loss orders. These act as a safety net and automatically trigger a buy or sell action when the stock price reaches a specified point. These orders can protect you against losses in stock trading as well as futures and options trading.
To sum it up
Leverage in the stock market can be a handy tool to trade in instruments that may be out of your reach. However, it is important to understand that it is a double-edged sword that can significantly enhance gains and amplify losses. Therefore, you must carefully understand its dynamics, risks, and benefits to employ this powerful strategy effectively.
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