This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Leverage is one of the most powerful tools in a stock trader's arsenal, and the leverage is also one of the most dangerous. The leverage that produces a 5 percent gain on a 5:1 position can produce a 5 percent loss, and the loss can be larger than the gain because of the spread, the commission, and the financing charge. The trader who understands the impact of leverage can design a strategy that uses the leverage wisely, and the trader can avoid the pitfalls that come with the leverage.
How leverage changes the risk profile
The leverage multiplies the exposure, and the multiplication changes the risk profile of the strategy. The trader who has a €10,000 account and uses 5:1 leverage on a €50,000 position has the same risk as a trader with a €50,000 account and no leverage. The risk is the same in dollar terms, and the risk is the same in percentage terms.
The leverage also changes the volatility of the returns. The leveraged position produces higher returns in good times, and the leveraged position produces higher losses in bad times. The trader's account equity swings more, and the swings can be psychologically challenging. The trader who is not prepared for the swings can make emotional decisions, and the emotional decisions can lead to losses.
How leverage affects position sizing
The leverage allows the trader to control a larger position with a smaller deposit, and the larger position requires a different approach to position sizing. The trader who uses 5:1 leverage can control five times the account, and the trader should size the position so that a 1 percent move in the underlying stock produces a 5 percent move in the account. The 5 percent move is the maximum loss the trader should take on a single trade.
The leverage also requires a more disciplined approach to the stop-loss. The stop-loss should be placed at a level that matches the trader's risk tolerance, and the stop-loss should not be moved against the trader. The trader who uses leverage without a stop-loss is exposed to the full move of the underlying stock, and the full move can wipe out the account.
How leverage affects the return potential
The leverage multiplies the return potential, and the multiplication is the main appeal of the leverage. The trader who uses 5:1 leverage can earn 25 percent on the account with a 5 percent move in the underlying stock, and the 25 percent is a significant return. The same move without leverage would produce 5 percent, and the 5 percent is a modest return.
The leverage also amplifies the loss potential, and the amplification is the main risk of the leverage. The trader who uses 5:1 leverage can lose 25 percent on the account with a 5 percent move against the trader, and the 25 percent is a significant loss. The same move without leverage would produce 5 percent, and the 5 percent is a manageable loss.
How leverage affects the trading strategy
The first impact is the holding period. The leveraged position pays a financing charge overnight, and the financing charge is a percentage of the position value. The trader who holds the position for weeks or months pays a significant financing charge, and the financing charge can erode the profits. The trader who uses leverage for long-term positions should compare the financing charge with the expected return, and the trader should consider a different strategy for long-term positions.
The second impact is the entry and the exit. The leveraged position is more sensitive to the entry price, and the leveraged position is more sensitive to the exit price. The trader who enters the position at a wrong price can lose more, and the trader who exits the position at a wrong price can give back more. The trader should use limit orders, and the trader should avoid market orders in fast-moving markets.
The third impact is the correlation. The leveraged position is more correlated with the underlying stock, and the correlation is closer to 1 than the correlation of an unleveraged position. The high correlation reduces the diversification benefit, and the high correlation increases the concentration risk.
How leverage affects the risk management
The first impact is the stop-loss. The leveraged position requires a tighter stop-loss, and the tighter stop-loss is necessary to limit the loss. The trader who uses 5:1 leverage should use a stop-loss that is 1/5 of the stop-loss the trader would use without leverage, and the tighter stop-loss limits the loss to the same percentage of the account.
The second impact is the diversification. The leveraged position reduces the diversification benefit, and the leveraged position is more concentrated. The trader who uses leverage should hold fewer positions, and the trader should be more selective with the trades. The trader who holds many leveraged positions is exposed to a large move in the market, and the large move can trigger multiple margin calls.
The third impact is the cash buffer. The leveraged position requires a larger cash buffer, and the cash buffer is necessary to cover the margin calls. The trader who uses leverage should keep 6 to 12 months of margin payments in cash, and the cash buffer protects the trader from a temporary market downturn.
Common questions about leverage and strategy
What is the best leverage for a stock trading strategy? The best leverage depends on the trader's risk tolerance, the trader's experience, and the volatility of the underlying stock. The conservative trader should use 2:1 to 5:1 leverage, and the aggressive trader can use 5:1 to 10:1 leverage on liquid stocks.
Can I use leverage for long-term investing? It is not recommended. The financing charge adds up over time, and the long-term return of stocks may not justify the financing charge. The trader who wants to invest for the long term should use a cash account, and the trader should use leverage only for short-term trades.
Does leverage change the optimal position size? Yes, the leverage allows the trader to control a larger position, and the larger position can be sized to a fixed percentage of the account. The trader should use a position sizing formula, and the trader should stick to the formula on every trade.
Related resources
Where to start
If you are evaluating leverage for your stock trading strategy, the most useful first step is to calculate the position size for a representative trade, and to compare the return potential with the risk. Our broker comparison lists the brokers that offer leveraged trading and the available leverage, which together tell you what the broker offers before you place the first leveraged trade.