Trading On Margin - Using Leverage to Trade Stocks

Updated: May 25, 2021

Applying Margin To Stocks To Improve Returns



Thanks for the visit, in this video, we talk leverage.

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In combination with some of the best material and personal knowledge, I hope to provide some basics regarding leverage and the use of margin to trade stocks.

The use of margin or leverage is often frowned upon within the trading community, and in many cases, rightly so, although this is generally due to its misuse or lack of understanding.

For the few that do fully understand, leverage can be very useful indeed.

The use of leverage however is extensively used in the wider financial landscape, and more commonly accepted through home ownership in the form of a mortgage.

The basic principle is the same for purchasing a property with a mortgage as it is for purchasing a stock on margin.

If we assume a property is worth $100,000, and we use a 90% mortgage to finance the purchase, this will require us to put $10,000 (or 10%) into the deal as a deposit, and the bank would provide the remaining $90,000.

Effectively we are using a $10,000 investment to control an asset worth $100,000, a leveraged ratio of 9 to 1.

If we also assume that home prices increased by 10% the following 12 months after purchase, we would have gained $10,000 in equity. However, the ‘return on investment’ would have been 100%, calculated by dividing the $10,000 deposit by the $10,000 equity gain. This is the power of leverage.

We must not however forget that the power of leverage can work against us too, if for example home prices dropped by 10% the 12 months after purchase, we would have returned a negative 100% return on investment. An example of a double-edged sword.

The concept of mortgaging a property as way of leverage, is widely seen as an acceptable method, however when it comes to using such leverage to purchase stock, the comparative use of margin is seen as less desirable.

A common leverage ratio used to purchase stock (through a margin account) is 2 to 1, this would mean we would need $5000 on account to control $10000 worth of stock.

The problem often arises when the uninformed or overconfident trader, begin to increase the leverage ratio, perhaps using the same $5000 investment to control $50,000 worth of stock. A recipe for disaster.

This is where the use of margin differs to that of a mortgage.

A mortgage requires strict affordability checks, ensuring the individual is not over exposed. Additionally, property is seen as a less volatile asset class.

Compare this to a margin account, where the individual can decide how much capital exposure they are willing to risk, on an asset class which can be highly volatile.

But how can we use a margin account to purchase stock, with acceptable exposure and risk, whilst achieving optimal returns? Let’s take a look…

First, we need to understand the strategy, if we do not know the historical performance of a strategy over varying market cycles, leverage should simply not be used.

If for example we used a 2 to 1 leverage ratio on a margin account, we could either double the profits or double the losses. If we established that the strategy or the stocks chosen could endure a 50% drawdown at any point, we could see a 100% or more loss of capital, with demands to liquidate our positions or add additional funds, often referred to as the dreaded margin call.

There is however a way to reduce the occurrence of significant drawdown, and therefore making the use of leverage a more acceptable approach. The main factor is the use of a stop loss.

In my opinion, using leverage or margin to trade individual stocks should never be considered if you do not use a stop loss, or have historical data to analyse past performance.

Let us put this into a more practical example by using our members portfolio in combination with the use of margin.

The current portfolio is made up of 12 selections, which is a typical holding quantity for me.