As many of my students know, I am an avid motorcyclist. What you may not know is that I also hold a certificate in motorcycle repair. As with my trading, I feel it is important to be able to fix things when they do not go well. If there is a problem with my bike or it needs routine maintenance, I can fix it. When there is something wrong with my trading, I can diagnose the problem and adjust my plan to improve my trading. This can only happen with the proper education and practice.
In a motorcycle, power is transferred from the engine to the rear wheel. This is done through a set of gears. To make the smaller movements of the engine gears generate more power to move the wheel, smaller gears are linked up to larger ones. This is known as gearing.
There is a way to get more power from your money in the markets as well. This is also sometimes referred to as gearing. It is trading through the use of leverage. Leverage is additional buying power given to a trader or investor in order to increase their trading exposure. Simply put, it is extra buying power.
Do not confuse leverage with margin. Margin is a good faith deposit placed with your brokerage or clearing house in order to cover any losses that may occur in a trade. Margin is the money you commit to the broker in order to be able to use leverage. Just because you place a certain amount of margin with the broker for a trade, this does not mean that you can only lose that amount in the trade. You can lose more than that amount and even more than what is in your account if you do not manage your risk properly.
An example of margin and leverage would be selecting to trade Reliance futures instead of trading Reliance Industries stock. The current price as of this writing was Rs. 785.20. If you wanted to buy 500 shares of the stock, you would have to pay Rs 392,600. However, when looking at the Sharekhan website, you could buy one Reliance futures contract that has the same value and price movement as the shares for a margin of Rs 62,253.
In this example, you are using margin of Rs 62,253 to receive leverage of 6:1. Your buying power is increased six times what you are placing as a deposit!
Margin and leverage can be a great thing. You can increase your returns. If Reliance Industries moved in your favor by Rs 10 per share, you would profit Rs 5000. On the stock trade, this is a gain of about 1.2% (5000 / 392,600). But on the futures trade with leverage, this is a gain of 8% (5000 / 62,253).
There is also increased danger when trading with leverage. Your rewards increase but also so do your risks! If the trade had gone against you, you could have lost 8% of your capital very quickly. So treat leverage with respect.
To learn how to manage leverage and other risks in the market, become fully educated in how to trade those markets. Joining a course at Online Trading Academy is a great way to start.