Ambitious DIY investors who want to amplify their gains have a powerful tool in their toolbox – leverage. Using leverage is a high-risk, high-reward strategy that can serve as a return multiplier, offering the potential to generate higher returns from less capital.
Defining leverage
Leverage is an investment strategy that uses borrowed capital to increase exposure to an investment beyond what a trader could buy outright with their own capital, offering the potential for greater returns from an investment.
Leverage acts as a return multiplier by allowing investors to control larger positions with a smaller amount of capital, thus amplifying both potential profits and losses. This is achieved by borrowing funds, often through margin accounts, to increase investment exposure.
The idea is simple. Investors use leverage to control a larger position with a smaller initial investment.
If the trade moves in your favour, the gains are magnified. However, if it moves against you, losses are equally exaggerated. For example, if a stock rises 5%, a 2x leveraged investment in that stock could deliver a 10% return.
However, while using leverage to trade on margin can serve as a return amplifier, it can also be a loss multiplier. In the previous example, if the stock dropped 5%, you could lose 10%.
But a drop in a stock price is not always a negative, as margin trading also supports short-selling. This opens up additional opportunities and greater flexibility for astute and experienced investors to generate a profit from market movements or changes in the prices of stocks or currencies in either direction.
Tools For Leverage
Modern trading platforms like Clarity, by Investec, allow investors to use the power of leverage to trade with margin through the use of contracts for difference (CFDs) and leveraged exchange-traded funds (ETFs).
CFDs are one of the most popular tools for gaining leverage in stocks and other asset classes. With CFDs, investors speculate on price movements without owning the stock.
If the contract price moves in the right direction, investors can amplify returns by earning a return on the entire contract value, not just the deposit.
Brokers typically offer CFDs with leverage ratios of 5:1 or higher, meaning you can control a R10,000 position with just R2,000 of margin. This makes CFDs attractive for short-term traders aiming to profit from market volatility. But they also require margin maintenance.
It is important to remember that CFDs already involve a level of risk, and margin trading adds another layer of complexity. So, make sure you fully understand CFDs and margin trading before trading with them.
For those not ready to navigate CFDs or margin accounts, leveraged ETFs offer a simpler way to gain exposure to leverage in stocks.
These exchange-traded funds aim to deliver 2x or 3x the daily returns (or losses) of an underlying index or sector. For example, a 2x leveraged ETF tracking the S&P 500 (VOO-NASQ) aims to double the index’s daily performance.
They’re easy to buy and sell, making them accessible to DIY investors. However, leveraged ETFs are designed for short-term trading, not long-term investing. Daily rebalancing can erode returns over time, especially in volatile markets.
Understanding Margin Trading
Margin accounts require collateral and are subject to margin calls if account equity falls below maintenance levels. Always ensure you understand the terms and risks, and never use margin to invest more than you can afford to lose.
As such, investors must approach margin trading cautiously and fully understand the mechanics and risks involved before trading with these instruments.
As an example, if a self-directed trader with R1500 in their investment account purchased a share (or a fraction of a share) without leverage and it increased 20% in value, they would’ve generated a R300 return (20% of R1500).
However, by using that capital as collateral to borrow another R1500 from the brokerage, they could’ve invested R3,000. In this scenario, the 20% gain would’ve generated a R600 return – a return multiplier of 2x with the same capital, which the trader gets to keep after paying back the borrowed R1500.
When to Use Leverage
When traders understand how to use leverage, it can serve as a powerful return multiplier. That is why it’s critical to understand how leverage works and the risks that come with leveraged trading.
New investors and traders should avoid highly leveraged products and start trading with their own capital before considering borrowing. Before you invest with leverage, build up some capital as a buffer to cover potential margin calls, even if you don’t immediately need them for trading. Use margin and CFDs sparingly and only with a clear risk management plan.
Avoid using more than 2:1 leverage, unless you are very experienced, and never risk more than a small percentage of your capital on a single trade.
Investors should use leverage with clear intent, such as:
- Short-term trading strategies.
- Hedging an existing position.
- Taking a tactical view on market momentum.
Leverage can serve as a powerful return multiplier for DIY investors who understand the mechanics and manage the risks. Whether through CFDs, margin trading, or leveraged ETFs, there are tools available to gain enhanced market exposure.
With discipline, research, and the right tools, leverage investing can unlock new opportunities for active DIY traders ready to level up their returns.
