What is Leverage?
If you’ve been looking into investing, margin is a term you may have already come across. But what exactly is it and is it a good idea to use?
To fully understand what margin is, you must first know about leverage.
Leverage has slightly different meanings in personal finance, investing and business however the general idea is that leverage is the use of debt to help achieve a financial or business goal.
Basically, it’s using borrowed money to try and make more money through investments.
A simple example of this is getting a mortgage for a house. If you were to pay 20% of the house price up front, the other 80% would be financed by the bank or whatever lender you are using. In this scenario, you’re using 80% leverage.
Although the house that you are living in may not seem like an investment, over time it’s value increases so if you were to ever sell it you would make a gain.
Leverage vs Margin
Now, you may be wondering how leverage relates to margin trading accounts?
Although interconnected—since both involve borrowing—leverage and margin are not the same. Leverage refers to taking on debt, while margin is debt or borrowed money a firm/individual uses to invest in other financial instruments. You use margin to create leverage.
How Margin Works
In margin trading accounts, your broker will allow you to purchase stocks and other financial instruments worth more than the amount of money in your account.
In exchange, the broker will charge you interest for the loan.
The amount that you are able to borrow is based on the amount of money that you have in your account.
For example, if your broker has an initial margin requirement of 50% (the percentage of the purchase price of a security that must be covered by cash or collateral when using a margin account) for every dollar you borrow, you would have to have a dollar in your account.
An investor may do this if they want to increase the potential gains that they could get from the stock they are invested in.
If you have $1,000 to invest and bought 10 shares in Company A for $100 each and sell them when the price gets to $12, you made $200.
With margin, if you had a 50% margin requirement you could use the same $1,000 to purchase 20 shares in Company A for $100 each and when they get to $12 each, instead of making $200, you would have made $400.
Not too shabby considering you invested the same amount of money personally.
As every broker offers different levels of margin, it is important to know what your broker offers.
The amount of money that you have available to buy securities in a trading context is called buying power.
Buying power equals the total cash held in the brokerage account plus all available margin.
This may sound great, I mean who wouldn’t want to make double the money without having to personally invest more, right?
What we’re not taking into account yet which in my opinion is the more important part to think about when buying shares in a company is what happens if it doesn’t go your way.
If the share price of Company A dropped by $2 instead of going up by $2, your $200 loss turns into a $400 loss.
This sounds really bad but let’s take it a step further.
What if Company A goes bankrupt and their stock price is now worth $0. With a non-margin investment, you would lose your $1,000 and that would be the end of it. It sucks, but at least you can walk away and try again another time.
If you use the 2:1 margin outlined above however, you don’t only lose your $1,000 but you also owe the broker another $1000. To make matters even worse, the $1,000 you owe the broker will also have interest added on top for as long as the debt is outstanding.
Some stocks are so volatile that they can drop enough to wipe out your account and put you into debt all in one day.
It is a good idea to set stop losses so that your shares automatically sell if the price were to drop to a certain price. I always recommend setting stop losses. You never know when a stock might have a big drop so it is always good to be safe.
Since the broker is the one lending you the money, they want to make sure that they will get it back eventually.
Brokers will have a maintenance margin requirement which is the minimum amount of equity that you have to maintain in a position in order for them to allow you to keep borrowing money.
This amount is typically around 25-40%
If the market value of your position drops below the accounts maintenance margin requirement, you will get what is called a margin call.
When this happens, you have a few options.
You can either add more money into your account so that you meet the threshold set by the broker, sell your position and then cover whatever debt you may have, or in extreme cases if you don’t do anything the broker will sell your shares themself and then you are responsible for paying them whatever you still owe.
As an investor, you shouldn’t let it get to this point unless you acknowledge the risks and do extensive due diligence.
Don’t Get Caught Up In The Bright Lights
As you do your research, I’m sure you will come across some posts that sound a little like, “How I Turned $100 into $100,000 in 30 days.”
Although some of these stories are true, most of them involve extreme levels of leverage.
For every 1 story you hear like this, there are another 1,000,000+ that ended horribly.
I’ve heard stories of people who have lost everything (house, family, car etc.) by using too much leverage in trades that went wrong.
It may sound exciting when you do the math and find out how much money you can make with leverage if the trade goes your way, but do not forget to calculate how much you will lose if it doesn’t.
Even the top investors in the world are not correct 100% of the time, don’t think that you will be the exception.
Should You Use Margin?
For new investors I would strongly recommend staying away from margin until you have become much more comfortable with trading.
There is a lot to learn when it comes to investing so do not put yourself in a hole right off the bat. Take it slow and learn as you go.
With investing, the goal is to make money overtime so it would not be very beneficial if you blow up your account early on trying to make quick money.