Leveraged trading refers to the use of borrowed capital, usually provided by a broker, to increase the potential return on investment. While leveraged trading can offer some benefits, it also comes with inherent risks.
While leveraged trading allows us to control larger positions with less capital, it is essential that we have enough funds to cover potential losses and margin requirements. Therefore, must ensure that we have sufficient financial reserves before embarking on leveraged trading.
Advantages of leveraged trading
Increased profit potential: By using leverage, we can amplify our return on investment. If our trade is successful, the profit earned will be based on the full leverage, rather than our initial investment.
Reaching higher positions: Leveraged trading allows us to control larger positions in the market with a smaller initial investment. This can give us exposure to assets or markets that would otherwise be out of our financial reach.
Diversification opportunities: With leveraged trading, we can diversify our portfolio by approaching different markets or assets. This has the potential to reduce risk by spreading our investments across multiple sectors.
Risks of leveraged trading
Amplification loss: Just as leveraged trading can magnify profits, it can also magnify losses. If our trade goes against will, the losses incurred will be based on the full leverage, potentially exceeding our initial investment.
Increased volatility: Leveraged trading can expose us to higher levels of market volatility. Even small price movements can have a significant impact on leveraged positions, resulting in quick gains or losses.
Margin call: When we trade on margin, we are essentially borrowing money and the loan amount is used as collateral. If the value of our investment drops significantly, the broker may issue a margin call, asking us to deposit more money to maintain our position. Failure to meet margin requirements may result in our position being closed at a loss.
Limited time: Leveraged trades usually have a predetermined time frame. If the market does not move in the expected direction during this time, we may be forced to exit the trade, which could result in a loss.
Interest and fees: Leveraged trading often involves borrowing money, which means we may incur interest charges on the borrowed money. In addition, brokers may charge fees or commissions for providing leverage, which can reduce our profits.
It is important to understand these benefits and risks before engaging in leveraged trading. Consider our risk tolerance, financial situation, and knowledge of the markets before using leverage and always ensure that we have a solid risk management strategy in place.
Leveraged Trading Can Offer the Following Benefits:
- Increase profit potential by amplifying return on investment
- Access larger market positions with less initial investment
- Opportunity to diversify by approaching different markets or assets
Leveraged Trading also comes With Risks:
- Exposure to greater market volatility, resulting in quick profit or loss. Possibility to request a margin, request additional funds or close a position.
- Limited trading time frame, leading to potential loss if expectations are not met.
- The fees and charges incurred can affect your overall profit.
It is important to fully understand these benefits and risks, considering our risk tolerance, financial situation, and knowledge of the markets before embarking on leveraged trading. Implementing a robust risk management strategy is crucial to mitigating potential downsides.
My Learnings as a Trader
Advantages of Leveraged Trading
Increased profit potential: Let’s say we want to invest in a particular stock that is trading at ₹100 per share and we expect its price to increase. Instead of buying 100 shares for ₹10,000, you decide to use leverage and borrow another ₹40,000 from the broker. With a total investment of ₹50,000, if the stock price rises to ₹120 per share, our investment will be worth ₹60,000, yielding a profit of ₹10,000 (minus any interest or any fee).
Reaching higher positions: Without leverage, our initial investment of ₹10,000 will only buy 100 shares. However, using leverage, we can control a larger position, such as 500 shares, by borrowing more money from the broker. Diversification opportunities:
Leveraged trading allows us to diversify our portfolio among different stocks on the Indian stock market. By approaching multiple stocks, we can minimize our risk and take advantage of different market opportunities.
Risks of leveraged trading
Amplification loss: If the stock price moves against our expectations, our loss will increase. For example, if the share price drops to Rs 80 per share, then our total investment of Rs 50,000 will be worth Rs 40,000, resulting in a loss of Rs 10,000 (minus interest or fees). It is important to note that losses can exceed our initial investment. Increased volatility:
Indian share prices can be volatile and leveraged positions are more vulnerable to large price movements. Small price movements can have a bigger impact on our investment due to the leverage factor.
Margin call: If the stock price drops significantly, our broker may issue a margin call, asking us to deposit more money to maintain our position. Failure to comply with margin requirements may result in our position being closed, potentially resulting in a loss.
Interest and fees: Leveraged trading involves borrowing money, which may incur interest. In addition, Indian stock market brokers may charge a fee or commission for providing leverage, which affects our overall profit.
It is essential to fully understand the benefits and risks of leveraged trading in the Indian stock market. Consider your risk tolerance, financial capacity, and knowledge of the markets before embarking on leveraged trading, and always have a well-defined risk management strategy.