Someone embarking on the journey of personal finance management through equity trading may at first become overwhelmed by the insignificance that their buying power plays when under the influence of the market forces. Many people – young investors and market skeptics alike – want to begin managing a diversified portfolio of assets, and set out to own the shares of multiple companies only realize that they cannot afford to.
A share of Apple ($AAPL) costs $156, a share of Google ($GOOGL) costs even more, $1005. Even if you look at the current TTM for Google’s share price the 20.3% gain on a holding of one share isn’t worth the $170 profit, stressful Bloomberg binges, and broker payments.
This is what makes leverage, or buying on margin, so attractive to lot of low capital investors.
Margin buying allows an investor to purchase a larger quantity of shares with leverage from their broker with less capital. In turn, the exposure of one’s position to gains and losses also increases.
Leverage can allow an investor to earn almost a 50,000% return on their investment in a year with a growth stock. $400,000 from an investment short of $1000, $4 million from $10,000, and they invest one million dollars…
The zeroes keep adding up, it seems like the perfect investment opportunity, but you can’t have your cake and eat it too. There are a few issues with buying stocks on leverage:
1. As your profits are maximized by the broker-provided leverage so are your losses. You may lose more money than you have put into your portfolio and receive a margin call from your broker requesting that you deposit more funds to keep the position afloat.
2. Any leverage beyond 1:10 is rare to come across in the stock market. In fact, the SEC (US Securities and Exchange Commission) strictly regulates which margin options broker are allowed to provide to their clients for given securities. Stocks with low book-to-market ratios generally have heavier restrictions on leverage than growth stocks.
So what is the point of examining what a 1:400 leverage can do to an investment if an investor will never come across the opportunity to exercise this level of margin?
While an investor may not be able to exercise the leverage on the U.S. equity market, they will be able to do so on the Foreign Exchange (FOREX) and with CFD (Contract for Difference) instruments.
However, this warrants the last issue with buying on leverage:
3. CFD Trading is banned in the United State because it is a decentralized financial instrument, and all financial instruments in the U.S. must be regulated by the SEC.
However, if you do find yourself trading on the FX markets or with CFD bear in mind the risks. CFD’s are different from equity because the investor never owns the asset, thus forfeits dividends, and cannot influence the market because a CFD only mirrors its underlying asset price. A CFD position also does not give a guarantee of a margin call, and contracts are terminated once initial funds are exhausted.
Once again, every stock movement is reflected in the positions total exposure.
A stock price changes multiple times a minute, both increasing and decreasing in value. Even those securities that outperform major indices have days when their share price decreases. The weekly standard deviation of the underlying asset can cause your CFD to close unexpectedly when high levels of leverage are exercised.
Outlined in the table below is the leverage responsiveness to volatility for a fictional stock with an initial price of $100 that is decreasing in value.
When trading with high leverage CFD’s it is important to eliminate as much short-term downside risk as possible before the asset gains momentum and the trade develops. Additionally, it is important to keep proper account of all undertaken leverage within a series of trades, and to consider ones trading behavior. The higher the leverage, the higher a role plays risk aversion.