If you have a brokerage account, you’ve probably heard people discuss whether or not it is convenient to use financial leverage to trade on equity. But what exactly does that mean?
Most brokers give you the option to use financial leverage to potentially increase your returns, but even if it is a good strategy, this is a risky way to invest.
What is financial leverage?
In simple words, leverage is using your broker’s capital to you have more money to make a larger investment. For example, if you alone were able to invest $10,000, with leverage you can invest $40,000. So now you can have access to 4 times more shares, commodities, bonds or any other product you invest in.
The more you invest, the higher the return. That is why leverage can potentially increase your return. If things go right, it is a great deal. But if it goes wrong, you will lose more money than the one you actually have right now.
Usually, your broker will require you to keep a certain percentage of what you borrowed in your trading account and this is ok as long as your investments perform well. But as the market fluctuates rapidly and unpredictably, this can be highly risky.
However, there are some ways to lower your risk while using leverage.
There is little room for mistakes as any margin call can be very costly, so it’s better if you wait until you have more experience with investing and trading before you consider this option.
If you decide to use leverage, consider doing so in safe investments. Although tempting, leverage can have disastrous consequences if not planned, so make sure you have a clear strategy and a well-crafted plan and stick to it.