Leverage refers to borrowing a certain amount of money in order to invest in something. In stock market, let’s say you have Rs 10,000 only but you wish to purchase stocks worth Rs 1,00,000. In such a scenario, you need a broker who will lend Rs 90,000 to you so that you can buy/purchase shares of the desired amount. Thus, if a broker offers you 10 times margin/leverage on your trading capital, you get to manage and control stocks amounting to a much larger sum of money than the initial trading capital.
How does leverage benefit us? Let’s say that in the above example, with a sum of money of Rs 10,000, we buy shares worth Rs 1,00,000 and the shares move up by 3%. So, we make a return of Rs 3,000 on Rs 1,00,000 i.e. a return of 3%; however our effective rate of return on capital will be 30% since we have made a return of Rs 3,000 on a trading capital of Rs 10,000 only. Wonderful, isn’t it? With stock brokers offering margin of upto 40 times on trading capital in intraday trading (intraday refers to buying and selling of stocks on the same day), this is a sure shot way to becoming rich quickly! Correct? Not really!
Let us know understand why leverage in trading is a double edged sword. In the same example, if the price of the purchased shares worth Rs 1,00,000 went down by 3%, then we would incur a loss of Rs 3,000 on a trading capital of Rs 10,000. This would be a massive 30% loss for someone with a small trading capital of Rs 10,000. Now, let’s say our broker was giving us a margin/leverage of 40 times on our trading capital and we had purchased stocks worth Rs 4,00,000 with a trading capital of Rs 10,000. If the stocks went down by 3%, we would lose Rs 12,000 on a trading capital of Rs 10,000 meaning that not only does 100% of our trading capital get wiped out; we also owe an additional Rs 2,000 to the broker who had offered us this leverage.
Brokers offer higher and higher leverage so that we can trade more and more so and they can make a lot of money since they earn money through brokerage only. However, small retail traders are known to have their accounts wiped out and all capital lost only because of being over-leveraged. One needs to be really careful about using this double edged sword, else destruction is in order.
Leverage is only for full-time professional traders who have been in the game for a lot of years and have learnt how to handle leverage. Also, leverage should be used in moderation while trading in stocks.