In this article, you can read how leverage in stocks works, its advantages, its risks and some calculations that will help you in your trading.
How Does Stock Leverage Work?
Stocks are the best-known financial asset and the one chosen by many to invest or trade. There are a wide variety of brokers that offer them in their instrument catalog and some allow you to trade with them using leverage.
What is Stock Leverage?
Leverage is a mechanism that allows you to invest with more money than you have in your account.
- Instead of paying the full price of the shares you buy, the broker allows you to pay only a part and he puts up the rest.
- It is usually expressed in the form of a ratio, for example 2:1 or 30:1 (in some places you could find it backwards: 1:2 or 1:30, it is the same thing).
- This nomenclature relates the amount of money you can use with respect to the amount you deposit.
- 2:1 means you can trade $2 by putting in 1 and 30:1 means that for every $30 your position is worth, you only need to pay $1 when you enter the market.
The amount you put in is called margin and the total amount of the position is called exposure.
- Some stock brokers do not use the term leverage and refer to margin as a percentage.
- If they tell you that the margin required to trade shares is 50%, it is the same as saying that you have 2:1 leverage.
Keep in mind that leverage and margin vary from one broker to another, from one account to another and even from one asset to another within the same brokerage company.
How to Calculate Leverage on Stocks?
To know the amount you must deposit when opening a position in leveraged shares, you need to divide the total price of the operation by the ratio that your broker provides you.
Imagine you are buying 5 Tesla shares at $911.99 and you have 4:1 leverage. The required margin would be:
- 5 x 911.99 = $4,559.95 (total position price)
- 4,559.95 : 4 = $1,139.9875 (margin required)
When your broker does not express leverage directly and tells you that the margin required to open that trade is 25%, you must calculate 25% of the total price:
- 25% 4559.95 = $1139.9875
If you don’t know exactly how many shares you can buy with your funds, you can do the calculation below. If you have 2,000 USD in your account and 10:1 leverage:
- 911.99 : 10 = 91.199 USD (margin required per share)
- 2,000 : 91,199 = 21 shares
- Total capital: (listing price: leverage ratio) = number of shares
Advantages of Investing in Stocks with Leverage
Thanks to leverage, you can trade with more money than you actually have in your account.
This gives you the following advantages:
- You can buy more expensive stocks: If you’re on a tight budget, you may not be able to afford to buy many of the hottest stocks if you don’t use leverage
- Larger position size: leverage allows you to buy a larger number of shares even if you do not have the necessary capital
- Higher profits: a movement of a few cents in your favor will result in higher profits, as you are trading with a larger position size
- Possibility to diversify: by not having to place a large amount in a single position, you can afford to open other trades in other stocks or even in other markets
Risks of Trading with Leverage in Stocks
As you have seen, leverage allows you greater exposure than you could achieve with your capital alone. This makes the potential profits multiply, but so do the losses.
- The variations in the price of your position are proportional to the total exposure and not only to the deposited margin.
- If the price moves quickly, you could lose all the capital invested.
Below is an example, continuing with the Tesla case.
If your equity is $200, available leverage is 100:1, and Tesla is trading at $911.99, you could purchase a maximum of 21 shares.
- Every time Tesla’s price goes up or down by 1 cent, you would gain or lose $0.21.
- Due to the increased exposure you get through leverage, a $9.52 drop in the price of this stock would result in a loss of all your funds.
- The broker would close your position and you would be left out of the operation.