Leverage trading is where trading can get a bit complicated. And if you’re not careful, those complications can blow up your account.
Using leverage for your trades can sound smart … Why drag something heavy with a rope when you could use a pulley instead?
And that example works … until you realize that trading with leverage goes both ways. And that pulley is a good idea until the heavy thing starts pulling you.
That’s why I’m a fan of the ‘measure twice, cut once’ school. That means you should study all the angles on leverage before you EVER trade with it. (Even then, I wouldn’t do it.)
So what’s the deal with leverage trading?
Why do I regularly roast loudmouth shorts about leverage trading my Twitter feed?
Let’s get into it.
Table of Contents
- 1 What Is Leverage Trading?
- 2 How Does Leverage Trading Work?
- 3 What Is Margin Trading?
- 4 Pros and Cons of Leverage Trading
- 5 How to Trade Stocks with Leverage: 5 Tips for Traders
- 6 Markets to Use Leverage Trading
- 7 Leverage Trading in Forex
- 8 How to Manage Risk With Leverage Trading
- 9 Examples of Trading on Leverage
- 10 Should You Use Leverage in Your Trades?
- 11 The Bottom Line
- 12 One Platform. One System. Every Tool
What Is Leverage Trading?
Remember your multiplication tables? Leverage trading will multiply your wins and losses … in some cases, up to 400 times.
Leverage trading works with options, margin, and other trading instruments. But it’s not all gravy. Whatever you’re multiplying your trading capital by also has the potential to go against you.
Looking for more resources on trading basics? Check out the StocksToTrade blog.
How Does Leverage Trading Work?
Let’s say you make a trade on margin. In this example, your broker allows you to borrow up to 50% of the size of the trade. You use the cash and securities in your margin account for collateral.
That’s one kind of leverage trading. In this case, your leverage is two times the capital you put in.
When you’re trading options, your leverage can go way up.
Let’s say you buy a call option — an option to trade a stock for what you think it will be worth in the future. You get the difference between the future stock price and the price when you bought the contract.
You buy a contract for $100, and it gives you the right to purchase 100 shares of a stock in four months. If the price goes up $1, you break even. If the price goes up $2, you make $100 … and so on.
If the price goes down, you lose your $100. In this case, your losses are limited, but the profit potential can be huge. That makes options trading sound simple. It’s not.
What Is Margin Trading?
Margin trading is one way to trade using leverage.
If you go long on margin, you’re probably leveraging twice the capital you’re putting up. You make twice your money if the stock goes up. And you lose twice your money if the stock goes down.
When you sell short, the math changes. Sure, you can make twice your initial capital if the price goes down. But let’s say it goes up … and keeps going up…
$10, $15, $20 … your initial investment gets wiped out, but you’re still on the hook until you exit the trade. And the leverage against your position keeps multiplying.
I’m typically against shorting these days, especially for new traders. It’s a tough and risky strategy.
Our SteadyTrade Team mentorship program is all about helping you learn to navigate the markets. In our twice-daily webinars, I tell you what I see in the markets and answer as many questions as I can.
If you’re contemplating shorting a stock, I’ll tell you what I think, but not what to do. Try breaking down trades with us. You’ll also get access to our massive video library. Plus, we archive all our webinars so you can go back and review any time.
Pros and Cons of Leverage Trading
Yes, there can be pros to leverage trading as well as cons. Let’s check them out…
Pro: Magnified Profits
The benefits of leverage trading start with amplified profits.
You put up a sum of money, then multiply that by your leverage … If you make money on the trade, you’ve made a whole lot of money.
Con: Magnified Losses
Like everything in the stock market, leverage is a two-way street. If you’re not considering loss potential, I’d say you don’t have a solid trading plan.
And don’t forget, you can get into dangerous situations with leverage. You have to stick to your stops.
Leverage makes it way easier to get overextended. And that leads to bigger losses.
Pro: Access to Higher-Value Stocks
When you factor in increased losses, leverage trading starts to lose its luster. And if you’re a new trader, you don’t want to be tracking several short-term trades at once.
So when might a trader use leverage?
Here’s one example … Let’s say you’re looking at a higher-priced stock like Tesla.
You could use leverage to take a bigger position than you could maintain with a cash account. There’s still risk … But you might think the odds align better for your overall market strategy. It’s all about your trading style, risk tolerance, and plan.
Con: More Fees
If you want to short a stock, there are borrow fees AND the margin rate. Options contracts can cost enough that even winning trades aren’t profitable.
Listen, I’ve always said that commissions and fees shouldn’t stop you from making a trade. If it’s a good trade, it should be worth it. But you can’t write off the large and complicated fees you pay to access leverage so easily. They can negate profits or turn a winning trade into a losing one.
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How to Trade Stocks with Leverage: 5 Tips for Traders
Even if you’re not planning on using it, you should know how to use leverage in stock market trading. Trading with leverage isn’t good or bad — it’s just another tool in your toolkit. And it’s always smart to know what’s available to traders.
1. Draw Up a Trading Plan
Use any strategy that suits you. Be sure to be thorough and do your research. Look for your entries, exits, and stops. And always stick to the plan. Remember, you want to build a solid case for every trade.
2. Define Your Risk
A good trading plan has a defined goal and defined risk. This is important for any trade, but it’s the most important thing for leverage trading.
If you only have a vague idea of the risk you’re taking on, you’re not making a smart trade. You might get lucky profit on the trade, … but you’ll eventually go bust.
A disciplined trader can have a 50% winning percentage and still profit. That’s because they contain their risk.
3. Have a Set Dollar Amount You’re Willing to Lose
Defining risk gets easier when you think in terms of the actual money you’re putting into the trade.
Maybe you’re willing to risk $50 toward a goal of $100 profit … Whatever your sweet spot is, get it into your trading plan.
Trading isn’t a video game. Thinking of your risk in terms of actual money will help you remember that.
4. Know the Fees and Commissions
Leverage trading is more complicated than going long on a stock. And fees and commissions can add up. Think ahead and account for all the possible additional costs.
5. Never Risk the Health of Your Account
Again, this is Trading 101 — but it’s doubly important for leverage trading.
The #1 goal in trading is to protect your account’s health. You do that by limiting risk and staying disciplined.
Markets to Use Leverage Trading
OK, we’ve talked mostly about stocks … but if you’re a leverage trading fan, you might want to go elsewhere.
One possibility is leverage trading cryptocurrency. But that’s nuts! Remember how I told you about limiting your risk? Good luck when you’re trading a coin that goes up or down by $5,000 in a few hours!
But the unregulated markets of the crypto trade have other ideas. Some exchanges will give you leverage 100 times your capital!
I guess it goes without saying — be very, very careful about this.
Leverage Trading in Forex
A more useful example of leverage trading is the forex market.
Forex trading deals with much smaller fluctuations. There’s less volatility and a lower potential for profit or risk.
In addition, the forex market is the most liquid market in the world. In 2019, it saw a daily volume of $6.6 trillion. That can mean less risk of being stuck in a position.
How to Manage Risk With Leverage Trading
This is the scary part of trading on leverage. Depending on your investment vehicle, leverage trading can get really out of hand.
If you’re trading options, you can limit your losses to the cost of the contract.
But if you’re leverage trading using a margin account, your losses can be massive. That’s why it’s essential to know what you’re getting into.
Your tools are the biggest thing you can control. And if you’re leverage trading, you need some good ones.
StocksToTrade can tell you everything you need to know about a stock. It’s got a powerful, customizable stock screener … as well as several pre-built screeners that help you find potential trades. Its research capabilities are second to none. Optional Level 2 gives you insight into what the market is doing in real time.
Examples of Trading on Leverage
Remember GameStop? That’s a great recent example.
First of all, the short interest was way out of whack. If you want to know what not to do … don’t do that.
These hedge funds got a bit too cocky … then someone noticed they’d shorted more stocks than were in the public float. They were teed up for one of the most epic short squeezes in memory.
But they weren’t the only ones using leverage. Many of the retail traders who squeezed the hedgies out of the market were also using a lot of leverage.
In the end, the hedge funds lost about $20 billion. And a ton of retail traders made and lost money too. If you’re looking for the best and worst of leverage trading, you’ll find it in there.
Should You Use Leverage in Your Trades?
I don’t think it’s a great option for most everyday traders. The call is ultimately yours. You know the risks now.
The Bottom Line
Leverage trading can be dangerous and can also lead to potentially big profits.
Like anything in trading, it’s just a tool. Working it into your trading plan is up to you.
If you’ve got questions on working leverage into your strategy, I’d love to see you on the SteadyTrade Team. We do twice-daily webinars to get into the nuts and bolts of trading.
Remember, I want you to measure twice before you cut once. That’s how you make sure you’re trading with discipline, win or lose.
What do you think about leverage trading? Or is it already part of your strategy? Let me know in the comments — I love hearing from you!