September 16, 2021

What is Leverage in Trading?

What is Leverage in Trading?
What is Leverage in Trading?

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Leverage, when taken literally, means an advantage in an endeavor through assistance. When using leverage as a verb its meaning is to have an advantage through using a tool like a lever. A lever creates the ability to move a heavy object that could not be lifted using effort alone. Leverage gives you the ability to shift weight exponentially by directing pressure.

Leverage is used in the financial world metaphorically. It is often used in the business world to express a strategic advantage over competition by using an existing edge in a market to build more upon that platform for success. Facebook bought Instagram and used its leverage in social media in both technology infrastructure and platform integration as leverage to grow its acquisition more quickly. 

In trading and investing there are several ways to use leverage.

One of the most common strategies is to use margin (borrowed capital) to amplify existing capital and increase profits for winning trades. If a trader doubles the buying power of their account and takes twice the size of a position than they could have with their capital alone it would double their returns. An all in trade that produced a 5% return on total capital would have produced a 10% return with double the size using leverage through margin. 

Margin can be a good tool for leverage by using it for turning over capital quickly for different trading positions and not having to wait for the trade to clear to reset buying power of capital but it can be very dangerous for trading too big and risking ruin. Always use margin responsibly inside proper risk management parameters. 

Another use of leverage is what you get with trading futures contracts. The exchanges that trade futures use initial margin requirements sometimes as low as 5% or 10% of the contract price that is being traded.

A crude oil futures contract could have a price quote of $100,000, and a futures trader would be allowed to take an long entry position with only a $5,000 deposit in a futures margin account. This example shows that 5% can allow you the leverage to hold $100,000 in contract value. Be aware that if the oil contract prices drops by $5,000 in value then your full account goes to zero, if it drops more you get a margin call and you owe money. If they contract goes up $5,000 in value you double your account value and have a 100% return on capital. This over leverage creates a very high risk of ruin. 

Margin capital for the futures market changes at times based on the risk of current price volatility for each market. 

Long option contracts are another type of leverage traders can use . While price of the option is your maximum capital exposed to the risk of loss the leverage of the upside profits are open. Options can be tools to increase the leverage of the capital that you have available and at the same time limit your risk to the downside. You can pay for the control of a high dollar value of shares of a stock with a small percentage of your trading capital. You have the potential for big wins and small losses built into options.

You can know the full amount of capital that you can lose when you enter into an option trade, the price of the option contract is your maximum risk exposure when you buy an option. With options you can control a large value of shares with a relative small amount of capital getting the full upside based on the Delta of your options. Option risk is in the price moving against your strike price or time running out before expiration. 

One of the most simple sources of leverage for stock traders is to use leveraged exchange traded funds. Leveraged ETFs track indexes or sectors but move two times or three times the magnitude of the underlier. These ETFS can be long or short (inverse) the markets they track.  They are are commonly called 2X and 3X ETFs.

Leverage is a tool for creating alpha and increasing the magnitude of your winning trades above your available capital. When using leverage you must always consider your risk of ruin based on position sizing, stop loss, and win rate parameters.