What Is Leverage in Stocks?
Stock trading with leverage can form a key pillar of your strategy and this guide will tell you all you need to know about how it works, the pros and cons and the different instruments available to you. Read on to find out more about ratios, margins and for practical examples that explain how leveraged stocks work.
What to expect from our guide to stock trading with leverage
What Is Leverage in Stocks?
Leverage allows you to borrow capital to increase your market exposure, enabling larger stock positions with less upfront capital. It enables you to open a leveraged position in stocks, using only a fraction of the capital required compared to direct investment. Leverage enables you to open a larger position in stocks, amplifying your market exposure while focusing on stock trading for this guide.
As an investor, you can use leverage to amplify your trading potential across various stock markets.
When you trade stocks using leverage, you create the possibility of magnifying your profits but there is also the risk of magnifying your losses. That's because you are exposed for the full position - not just the margin - and the amplification of those profits or losses will depend on your leverage ratio. Let's define what those key terms mean.
What is meant by margin when stock trading with leverage?
The margin is the capital required to open a leveraged trade position in stocks. This is known as the deposit margin and will typically be displayed as a percentage. The margin requirements will differ depending on your broker and the asset that you are looking to trade. For example, the margin for leverage trading stocks might be 20% whereas for trading forex it might only be 5%. Here's a practical illustration using those figures:
For stock trading with leverage
- You want to open a position worth $10,000
- The margin requirements are 20%
- You need to put up $2,000, rather than the full amount
For forex trading with leverage
- You want to open a position worth $10,000
- The margin requirements are 5%
- You need to put up $500, rather than the full amount
Then there is the maintenance margin, which is the amount of capital that you need to have in your account in order to keep a position open, in the event that you start to make a loss on a trade. If your losses exceed your maintenance margin, your broker will issue a notification, known as a margin call. If you fail to act, your position could be closed down.
Find out more in our in-depth guide to trading on margin.
What is meant by ratio when stock trading with leverage?
The degree of leverage at your disposal will be displayed as a ratio. For example:
- 5:1
- 10:1
- 20:1
- 30:1
The first number in the ratio reflects by how many times your margin will be multiplied. This ratio determines how much you can increase the amount of your market exposure relative to your margin. Let's assume that you have $1,000 of capital to put up as your deposit margin. Using the leverage ratios quoted above, your total position value would be:
- $5,000 (5 x $1,000)
- $10,000 (10 x $1,000)
- $20,000 (20 x $1,000)
- $30,000 (30 x $1,000)
Find out more about leverage trading with Tradu.
How do leveraged stocks work?
You can use leverage in stock trading to go long or short, so you have the potential to make a profitable trade in both bearish and bullish markets - as long as your prediction proves correct. Below is a theoretical example of a long position involving Company XYZ:
- Company XYZ has a buy price of $200 per share.
- Based on your analysis, you predict the market price of Company XYZ’s shares will rise.
- You therefore want to go long on Company XYZ and you wish to buy 100 shares.
- This amounts to a total position of $20,000 (100 x $200).
- To open the position, your broker requires a 20% margin.
- Rather than putting up the full $20,000, then, you are only required to put up $4,000 (20% of $20,000). By leveraging, you essentially borrow money from your broker to fund the remaining $16,000 of the position.
- The share value of Company XYZ increases as you predicted, to a sell price of $210.
- You opt to close the position, having made a profit of $1,000 (100 x $10) - before any fees or charges are deducted.
- Conversely, if your prediction proves incorrect and the value of Company XYZ falls from $200 to $190, you incur a loss of $1,000.
With leveraged stock trading, profits and losses are based on the full position value, not just your initial investment as the deposit margin.
How can you trade stocks with leverage?
Typically, when using leverage to trade stocks, you use a derivative instrument. This means that you are not taking ownership of the underlying asset - so, in the example of Company XYZ used above, you are not acquiring shares in that business. Instead, you are simply speculating on the performance of its share price. One of the primary derivative products for stock trading with leverage are contracts for difference (CFDs).
Stock trading with leverage: CFDs
This is an agreement between a buyer and a seller to exchange the difference in an asset's value between the time when the contract opens and when it closes. There is typically no expiry date on CFDs, although there are some exceptions.
Find out more in our detailed guide to CFD trading.
What are the benefits of using leverage when trading stocks?
Trading stocks with leverage offers a number of potential advantages:
- It provides the opportunity to amplify your profits while you're only required to put up a fraction of the full value of the position.
- Leveraged products like CFDs allow you to trade both ways, so you have the potential to make a profit if you think that an asset's value is set to fall. This is known as opening a short position.
- Putting down smaller deposits frees up more capital to open additional positions - whether that be in other stocks or different asset classes. This allows you to allocate additional funds to diversify your portfolio across multiple markets or asset classes.
- Hours may vary depending on your broker and the stocks that you choose but you can typically trade 24/5 and even out of hours in some cases.
What are the risks of using leverage when trading stocks?
It's important to bear in mind that there are no guarantees of success when stock trading with leverage. Some of the risks include:
- Trading on margin carries a significant risk of losing capital, as losses are amplified just like profits. You need to be mindful that you are exposed for the full value of your position and not just the deposit amount that you put down.
- Trading with leverage via derivatives - rather than dealing directly in stocks where you take ownership of the underlying asset - means that you will not receive the dividends afforded to shareholders.
- You are likely to be charged for maintaining any positions overnight and these costs - especially for longer-term trades - will eat into any potential profits.
Leveraged stock trading carries a high risk of amplified losses, as price movements impact the full position value.
What are the alternatives to stock trading with leverage?
Unleveraged trading, such as investing directly in a company's shares, is an alternative to stock trading with leverage. Unlike leveraged trades, you are taking ownership of the underlying asset. It also means that you are required to put up the full value of the position and can only make a profit if the share value increases.
One positive of unleveraged trading is that your losses are finite. There is no leverage ratio to take into account, so any losses are capped at the amount which is equal to what you initially committed to open the position.
Can you leverage stocks with Tradu?
Yes, you can start stock trading with leverage today. We offer a CFD trading account through our proprietary platform, which features a host of outstanding analytical tools to help you to monitor the markets, analyse trends and shape your strategy.
Once you've opened your account, decide which stocks you want to trade and make sure that you understand our leverage ratios, margin requirements and their implications for your position. If your prediction proves correct, you stand to make a profit which could create further opportunities for future trades however there is always a risk of losses if your position moves against you.