Leverage allows traders to amplify their exposure to an underlying asset without needing to commit the full value of the position. It enables traders to control a larger notional value of assets than their available capital would typically allow. Leverage is expressed as a ratio, such as 10:1, indicating that for every unit of trader’s capital, they can control ten units of that underlying asset.
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In derivatives trading, leverage is often provided by the broker or exchange. It allows traders to enter larger positions with a smaller fraction of the total contract value as collateral, known as margin. Leverage enables traders to capitalize on even small price movements of underlying assets, potentially leading to substantial profits.
How Does Leverage Work?
Trading Without Leverage
You have INR 1,00,000 in your trading account, and you want to buy shares of ABC Corporation. The current share price is INR 100.00 per share. You buy 1,000 shares, so your investment is INR 1,00,000. If the share price goes up by 5%, you can sell out of your position for INR 105.00 per share:
Return: 1,000 shares x INR 105.00 = INR 1,05,000
Profit INR 5,000 (or 5%)
Trading With Leverage
When you use leverage, you can get exposure to many more shares than you could buy outright. For example, when you buy ABC Corporation shares using 20x leverage, you could get exposure to 20 times as many shares, i.e. 20,000 shares, but only commit 5% of the money (called margin deposit or initial margin):
Current share price: INR 100
Actual Cost (margin) INR 1,00,000
Exposure INR 20,00,000
If the share price goes up by 5%, you can sell out of your position for INR 105 per share:
Return: 20,000 shares x INR 105 = INR 21,00,000
Profit INR 1,00,000 (or 100% of your INR 1,00,000 investment)
Pros of Using Leverage
- Increased Profit Potential
One of the main advantages of using leverage is the ability to generate higher profits. By borrowing funds to invest in assets, traders can magnify their gains. For example, if a trader invests INR 10,00,000 in stock and the stock rises by 10%, they would make a profit of INR 1,00,000. However, if the trader uses leverage to invest INR 1,00,00,000 in the same and the stock rises by 10%, they would profit INR 10,00,000.
- Access to More Trading Opportunities
Another benefit of using leverage is the ability to access more trading opportunities. With limited capital, traders may be unable to invest in certain assets or markets. However, with leverage, traders can access a broader range of opportunities, potentially leading to higher profits.
- Flexibility
Leverage also provides traders with more flexibility in their trading strategies. Traders can use leverage to take advantage of short-term market fluctuations or to hold positions for long periods of time. This flexibility can help traders adapt to changing market conditions and improve their overall trading performance.
Cons of Using Leverage
- Increased Risk
A disadvantage of using leverage is the increased risk. When traders borrow funds to invest in assets, they essentially use debt to finance their investments. That means that if the investments do not perform as expected, the trader may lose their initial investment also, owing money to the lender.
- Margin Calls
Margin calls are another risk associated with using leverage. When traders use leverage, they are required to maintain a certain level of equity in their accounts. If the value of their investments falls below this level, the broker may issue a margin call, requiring the trader to deposit additional funds to cover the losses. If the trader cannot meet the margin call, the broker may liquidate their position, resulting in significant losses.
- Psychological Pressure
Using leverage can also create psychological pressure for traders. The potential for higher profits can lead to greed and overconfidence, causing traders to take on more risks than they can handle. That can lead to impulsive trading decisions and ultimately result in significant losses.
Conclusion
Leverage is a powerful tool in derivative contracts and trading that can possibly lead to substantial profits and gains. But it comes with inherent risks, which demand a disciplined and cautious approach. Investors should prioritize risk management practices, such as prudent position sizing, setting stop loss orders, diversification, and continuous monitoring. By understanding the benefits and drawbacks of leverage and implementing effective risk management strategies, traders can harness its potential while safeguarding their capital from excessive losses. As with any particular trading endeavour, education, preparation, and a comprehensive understanding of leverage are essential for successful and everlasting trading in derivative contracts and making sound and safe investment decisions.
