Leverage is the ability to trade a large position (i.e. a large number of shares, or contracts) with only a small amount of trading capital (i.e. margin). Every so often, I read articles or blog comments that suggest that trading using leverage is risky, and that new traders should only trade cash based markets (such as individual stock markets) and avoid trading highly leveraged markets (such as the options and warrants markets). I disagree with this completely. Trading using leverage is no more risky than non leveraged trading, and for certain types of trading, the more leverage that is used, the lower the risk becomes.
Why Leverage is Incorrectly Considered Risky
Leverage is commonly believed to be high risk because it supposedly magnifies the potential profit or loss that a trade can make (e.g. a trade that can be entered using $1,000 of trading capital, but has the potential to lose $10,000 of trading capital). This is based upon the theory that if a trader has $1,000 of trading capital, they should not be able to lose more than $1,000, and therefore should only be able to trade $1,000 (e.g. by buying one hundred shares of stock at $10 per share). Leverage would allow the same $1,000 of trading capital to trade perhaps $4,000 worth of stock (e.g. by buying four hundred shares of stock at $10 per share), which would all be at risk. While this is theoretically correct, it is the way that an amateur trader looks at leverage, and is therefore the wrong way.
The Truth About Leverage
Leverage is actually a very efficient use of trading capital, and is valued by professional traders precisely because it allows them to trade larger positions (i.e. more contracts, or shares, etc.) with less trading capital. Leverage does not alter the potential profit or loss that a trade can make. Rather, it reduces the amount of trading capital that must be used, thereby releasing trading capital for other trades. For example, a trader that wanted to buy a thousand shares of stock at $20 per share would only require perhaps $5,000 of trading capital, thereby leaving the remaining $15,000 available for additional trades. This is the way that a professional trader looks at leverage, and is therefore the correct way.
In addition to being an efficient use of trading capital, leverage can also significantly reduce the risk for certain types of trades. For example, a trader that wanted to invest in ten thousand shares of an individual stock at $10 per share would require $100,000 worth of cash, and all $100,000 would be at risk. However, a trader that wanted to invest in exactly the same stock with exactly the same potential profit or loss (i.e. a tick value of $100 per 0.01 change in price) using the warrants markets (highly leveraged markets), would only need a fraction of the $100,000 worth of cash (perhaps $5,000), and only the $5,000 would be at risk.
Trade Using Leverage
In other words, the more leverage the better. Professional traders will choose highly leveraged markets over non leveraged markets every time. Telling new traders to avoid trading using leverage is essentially telling them to trade like an amateur instead of a professional. Every time that I trade a stock, I always use the highest leverage I can (usually the options and warrants markets), and I would never trade a stock without using leverage (and the same goes for all of the professional traders that I know). So, ignore all of the articles, comments, and even SEC warnings regarding leveraged trading, and the next time that you are making a stock trade, consider using a leveraged market instead.
Further information regarding leverage is available in my previous article about trading using leverage.