What is leverage and how to use it?

Find out what leverage is, in what contexts it can be used, and how. We will also see in this article, the advantages that explain its success with investors but also the risks it poses to traders who use it.

What is leverage?

Getting into debt to invest is what every economic actor does in the course of a lifetime, to buy a house for example. At the end of the repayment of a real estate loan, if the interest rate is reasonable, you usually own a property whose value is higher than what it cost you. This practice is also common in the financial world. It consists in investing more than your initial capital. But be careful, it is necessary that the level of indebtedness does not jeopardize the initial capital. This is why leverage can turn into a nightmare when it is poorly controlled.

Leverage: an investment practice that applies to many financial products

The leverage of the SRD

In the equity market, the possibility of taking a position with leverage, associated with a subsequent payment, is found in the SRD (Service de Règlement Différé). For a transaction made on the x of the month, the payment is made on the last day of the trading month. But the SRD is only possible on certain large capitalizations.

When you invest with the SRD, the prerequisite is the signature of an agreement with a financial intermediary (bank, broker). To take a position, you must fund your account with a number of assets as a "guarantee" so that you can then buy more assets. This collateral allows the financial intermediary to ensure that you will not default. The intermediary also charges you a commission for this service. Be careful, not all brokers offer the SRD.

On the SRD, the maximum leverage is 5, but only for assets in the form of cash or money market funds (the least risky). The maximum leverage is 4 for bond collateral and funds invested in bond assets (slightly more risky) and 2.5 for equity collateral and funds invested in equities (the riskiest assets on the DRS).

In other words, if you have $1,000 worth of stocks or equity funds in your account, you can buy assets worth 2.5 times that $1,000, or $2,500.

In the case of the SRD, the leverage is therefore limited. Derivatives allow you to use much more leverage.

The leverage of derivatives

An option is a right to buy or sell an underlying asset (stock, index, or commodity) at a specified price for a specified period of time in exchange for a premium. There are two types of options: calls, which give the right to buy an underlying asset, and puts, which give the right to sell an underlying asset. The purchase or sale of options makes it possible to use leverage, which amplifies the fluctuations of the underlying asset upwards or downwards.

In practice, the financial intermediary asks for a minimum amount in your account, the margin, which allows you to take a position for a higher amount. He then lends you the rest of the amount.

For example, it is possible to have a leverage of 10 for an option: when the underlying asset changes by 2%, the option changes by 20%. The use of options can thus increase performance, but it can also increase losses.

The complexity of options or the margin principle may lead you to prefer stock market products such as turbos, which are also easier to handle. These can also offer a much higher leverage than the SRD, with the possibility to trade on the rise (call) or fall (put) of the price of an underlying asset. But the maximum potential losses are limited to the capital invested, unlike the losses on options which can be infinite. However, the risk remains real for the trader: losing all of the capital invested can be a catastrophe.

The advantage of leverage: investing more than the amount invested

Many derivative products allow the use of leverage. Let's take the example of a derivative product with a leverage of 10: if you have a capital of $1,000, you can invest $10,000. You can therefore invest a much larger amount than your initial investment and potentially increase your profits tenfold.

If the price of your derivative's underlying asset rises by 10%, you will earn $1,000 (compared to a gain of $100 if you had not used leverage). You have therefore doubled your initial capital (+100%) with leverage.

The disadvantage of leverage: taking a higher risk than your investment

But beware, leverage is a double-edged sword that can be particularly dangerous if you don't anticipate it correctly. For example, if we go back to the previous example and you invested $1,000 with a leverage of 10, you could lose your entire initial capital. In fact, if the price of the underlying asset falls by 10%, you will lose $1,000 even though you have only invested $1,000, thus losing your entire investment.

Our tips for using leverage

Understand the mechanism at work

Before using leverage, it is very important to understand the benefits and risks involved. In particular, you need to be aware of the potential for gains and losses each time you use it. It is therefore important to take into account the characteristics of the derivative product being traded in order to benefit from the leverage effect. Indeed, investing in an option requires a good understanding of the time value, on a turbo to master the concept of disabling barriers, etc.

Limit your leverage

Also, you should not allow yourself to be tempted by exorbitant leverage, under the pretext that it allows you to minimize your capital.

A beginner trader who wants to achieve good results in the medium to long term should limit himself to maximum leverage of 5.

This is the maximum leverage for using the SRD. The idea is to always adapt your leverage to your risk profile.

Take the volatility of the underlying asset into account when determining the leverage

The level of leverage should also be adapted to the underlying asset. The higher the volatility of the underlying, the lower the leverage of the derivative used.

When the derivative you are positioned in turns against you, the margin initially deposited in your account can be used up, in which case your broker will ask you to top up your initial capital. This request from the broker is called a margin call. Some brokers make this call before cutting your position so that you can decide for yourself what action to take (putting money back into the account to extend the position or cutting the position and not adding money), while others automatically cut the position at the same time they make the margin call.

To prevent your savings from melting away, you need to set profit and loss targets in advance, beyond which the position is automatically cut off, with stop loss and take profit orders. These simple orders, programmed when you take a position, will allow you to realize your winning scenarios or to limit the damage in case of bad anticipation.

As you can see, leverage is reserved for investors or traders who have acquired significant experience in the markets. Practice before you let yourself be tempted. Many online brokers offer demo accounts that allow you to familiarize yourself with the financial markets, but also with stock market orders, derivatives, and... leverage!

All our information is, by nature, generic. It does not take into account your personal situation and does not constitute in any way personalized recommendations for the realization of transactions and cannot be assimilated to a financial investment advice service, nor to any incitement to buy or sell financial instruments. The reader is solely responsible for the use of the information provided, without any recourse against the publishing company of Cafedelabourse.com being possible. The publishing company of Cafedelabourse.com cannot be held responsible for any error, omission, or inappropriate investment.

Any trading activity involves risks. The order execution service through a limited risk account presents a risk of loss of the invested capital.

Options and turbos are complex financial instruments with a risk of capital loss. Losses can be extremely rapid.

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