Leverage Risk

Traders also face the endless challenge of how to make the best use of capital, based on their risk tolerance and willingness to use borrowed funds. Investors have to contend with this as well. Do they limit investments to available cash or use margin accounts to virtually double their potential positions? The more leveraged a position, the more profit potential and the greater the risk of loss.

For traders, leverage is just as much of an issue. However, because traders tend (generally) to be willing to assume higher levels of risk than investors, their leverage risk may be greater as well.
With more potential for loss, leverage may mean much greater dollar value to loss as well as dollar value to potential profit. This is a reality for traders, and as a consequence many will limit their use of basic tools such as margin accounts simply to keep risks low even in trading strategies demanding greater risk levels. So the overall risk should be part of the equation for traders; greater risks associated with short-term trading can be made even greater by also maximizing the use of a margin account, for example.

Key Point

Leverage is a great way to double or triple your profits; it is also an efficient way to expand your losses just as quickly.

To keep this in perspective, ask yourself: Would you max out a homeowners' equity line of credit (HELOC) to free up funds to trade stocks? Most people would reject this as too high-risk and also as an action likely to threaten the security of their home. However, the same people who would deem using home equity too risky might use a margin account to double up their positions in stocks. If the stocks lose market value, the money borrowed in a margin account has to be repaid.

For example, assume you have $20,000 in cash. Under the margin rules, you have to maintain 50 percent in cash and securities, meaning you can borrow $20,000 in your margin account and create stock positions of up to $40,000. If the prices of stocks go up 20 percent, the $40,000 placed into shares of stock increases in value to $48,000. The $8,000 profit is great, and is twice what you would have profited using only cash. However, what happens if the positions lose 20 percent? Now the account is valued at only $32,000. Because you have to maintain that 50 percent value in your margin account, you would get a margin call from your broker, and would be required to either come up with another $8,000 or sell some of your holdings. The $8,000 would restore value to $40,000 and satisfy the 50 percent margin requirement. If you do not meet the margin call, your broker then sells $8,000 of your holdings. This reduces your account value to $24,000 and also reduces your margin to $12,000.

Leverage risk for traders based on maximum margin can be described as the risk of losing twice as much in exchange for the potential of gaining twice as much. Before creating maximum margin positions, it is important to understand this risk and to be willing to accept it or, if not, to avoid margin trading altogether.

Key Point

Margin-based investing is simply getting access to the potential for doubling profits . . . or losses.

Another way that traders use leverage is through the use of options in addition to buying and selling shares of stock. Options are intangible contracts to buy or sell lots of 100 shares of stock. They cost only a fraction of what it would cost to trade 100 shares, and that is where options are so attractive and have become popular as a trading and speculative tool.

Options are attractive not only as speculative tools, but also as a means for managing a portfolio. For long-term investors, options can provide insurance for paper profits, or create short-term profits for no added market risk. However, they are complex instruments and are more completely explained in Basic Long Option Strategies.

For the moment, it is only necessary to understand that options are excellent leverage products. However, they involve specific types of risk. Your brokerage firm will allow you to trade options only once you have established your experience in options trading and knowledge of risks. You also need to maintain a level of account value in order to trade options, which requires a margin account; and brokerage firms require minimum account value before the margin account is available.

Brokerage firms assign trading levels for options trading. Under the lowest level, you are allowed only the most basic of trading techniques. More than any other method of trading, options are complex in terms of the jargon and sheer number of possible strategies. Some are very high-risk and others are quite conservative. Remember, however, that as with all kinds of strategies, knowing the range of risk is the essential first test you need to pass before placing money into the market. This applies to options and other forms of leverage more than with the act of just buying stock.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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