Leverage: A Double-edged Sword

Published by Sharekhan Education | January 14, 2023

Leverage is a double-edged sword. Where leverage refers to using borrowed capital, such as debt or financial instruments, to increase the potential return on investment. Leverage allows traders to increase their potential gains by investing more money than they have available. But it also increases the potential risk of an investment because it amplifies the effects of both positive and negative changes in the value of the investment.

Various types of leverage include:

Borrowing from Bank:

There are various types of leverage that traders can use. One common method is borrowing money from a bank or broker. For example, an investor might borrow from a broker to purchase more stock than they could afford on their own. If the stock rises, the investor can sell for profit and repay the borrowed amount with interest. However, if the stock price goes down, the trader may suffer a loss because they will still be required to pay back the borrowed money even if the value of the stock has decreased.

For eg. Trader ‘X’ has a capital of Rs. 10,00,000 and invests in a stock. If the stock prices go up by 20% his capital will appreciate by 20%, i.e. 200,000. And vice versa in case the stock goes down by 20%.

Trader ‘Y’ has the same capital of Rs. 10,00,000 and takes leverage of 4x (4 times the capital), thereby making an investment of 50,00,000 in the stock. In the case where the stock price goes up by 20%, it makes him a profit of Rs. 10,00,000 thereby making a return of 100% on the capital. But on the other hand, if the stock drops by 20%, he faces a loss of Rs. 1,000,000, wiping out his entire capital.

Another method of leverage is by pledging stocks. It allows an investor or trader to borrow money from a broker to buy stocks, or trade derivatives products.  The trader is required to maintain a certain level of equity in the account, and the broker may sell the securities if the equity falls below this level. Pledging can be risky because it allows investors to take on a large amount of debt relative to the value of the securities in the account. If the value of the securities decreases, the investor may be required to deposit additional funds or sell securities to maintain the required equity level.

Leveraging Futures and Options:

Leveraged financial instruments, such as options and futures contracts, can also be used to increase leverage. Options give the holder the right, but not the obligation, to buy or sell an asset at a specific price on or before a certain date. Futures contracts are agreements to buy or sell an asset at a specific price on a future date. Leveraged financial instruments can be complex.  They may be more suitable for experienced investors or traders who understand the risks and can manage their leverage responsibly.

It is crucial for investors and traders to carefully consider the potential risks and rewards of using leverage and to manage their leverage responsibly to avoid excessive risk. Leverage can be a useful tool for experienced investors and traders, but it can also be risky for inexperienced investors and traders who may need to fully understand the potential risks , even financial leverage is known as double edged sword.

In addition to the risks associated with leverage, investors/traders should also be aware of the costs of borrowing, including interest rates and other fees. Investors/traders should carefully review the terms of any borrowing agreements and consider the potential impact on their investment returns.

Conclusion:

Leverage can be a powerful tool, but it is essential to understand the potential risks and manage leverage responsibly to minimize the potential for losses. Trading with leverage without knowledge, education, or proper risk management can lead to capital erosion or even beyond.

By Prem Punjabi | Sharekhan Education

By Enrolling in this stock market course, you can learn the various aspects of trading in Futures and Options trading.