The New Investor’s Essential Guide to Leverage
Most brokers give you the possibility to use leverage to increase potential returns. Using leverage is a risky way to invest, but it can be a good strategy if you have a solid position.
There are a few things to be aware of before using leverage, and it’s best to wait until you have experience with investing before you consider using this option.
What is Leverage?
Leverage is using your broker’s capital to make a larger investment than you would be able to with your own money. So you’re leveraging your money.
For example, maybe you have $10,000 to invest. Using leverage would enable you to make a larger investment, perhaps $30,000. So you would control 3 times the shares, commodities, real estate, or other product with your $10,000 than you could before.
If the investment makes a profit, a larger investment in that item will bring you greater profits than what you would have made with your own money. On the other side of the coin, though, is the possibility of losing more than you would have if you had only used your own money.
Typically, brokers require you to keep a percentage of the amount you borrowed in your account. Your broker gets the rest of his money back, plus interest, from the investment’s profits.
Why Should You Use Leverage?
The main advantage of using leverage is to boost your potential profit. You can only earn so much with an investment with a 5% yield if you invest your own money, but using leverage means you can invest a lot more and the 5% yield turns into a more profit.
Leverage also allows you to gain exposure to investments that would require you to tie up an unsafe portion of your capital. This is especially useful with products such as futures contracts where a large initial investment is usually needed and the potential profits make using leverage worth it.
Are There Any Downsides?
The downside of using leverage is that your broker requires you to always keep a certain percentage of what you borrowed in your trading account. This is not an issue as long as your investment performs well.
However, market fluctuations make using leverage risky, since more money could be needed to purchase the futures contract you were interested in.
If this happens, your broker will place a margin call and require you to deposit more money in your account to cover the minimum percentage you are required to keep in your account. This means a dramatic shift in the market you invested in could become very costly.
How Can You Avoid Taking Risks When Using Leverage?
There are a few things you can do to avoid losing money when using leverage:
- Wait until you have more experience with investing and trading before relying on leverage. There is little room for mistakes since margin calls can be very costly.
- Use leverage on relatively safe investments. If too many factors are unknown, or if you don’t have good reason to believe an investment is safe, you’ll probably fail to generate the kind of profits you were expecting, even with leverage.
- Establish a detailed strategy. Ideally, you should have an exit strategy that allows you to limit losses in case you get close to a margin call. Meeting a margin call is usually a sign that you have made a mistake.
- Go over the terms and conditions your broker requires you to follow when using leverage. You’ll learn more about margin calls and the minimum amount you’re required to keep in your trading account.
In the end, using leverage can lead to higher yields as long as you invest carefully and select the right investment products.
However, using leverage can have disastrous consequences if things do not go as planned. This is why it’s crucial to have a detailed strategy going in and to properly assess the risks you are taking. These precautions can help you make the most from leverage.