Trading with leverage is one strategy you can use in attempt to increase your returns. Because trading with borrowed funds increases your market exposure, there is a potential for increased gains as well as increased losses.
Four Ways to Use Leverage
1. Bullish Strategy: Buying on Margin – Whether you're trying to take advantage of an upswing in anticipation of promising earnings reports or other market events, margin offers you a way to amplify your exposure to the market in attempt to increase your returns.
For example, let's say you buy 1,000 shares of XYZ at $10. When you're trading on margin, you're typically required to put down an initial investment equal to 50% of the purchase and your brokerage lends you the other 50%. In this example, the total cost of the purchase is $10,000, which means that your initial investment is $5,000 and you borrow the other $5,000.
If you sell your shares of XYZ at $12 per share, the total proceeds of the sale would equal $12,000. You'll need to pay back the margin loan ($5,000), which would leave you with $7,000. Since your initial investment was only $5,000, this would be a 40% gain. If you had used $5,000 cash to make your initial purchase, you would have been able to buy half the number of shares (500 shares at $10 per share). If the stock went to $12 per share and you sold your 500 shares, you would have profited $1,000 – a gain of 20%.
Note: This example does not account for commissions or interest.
2. Bearish Strategy: Short Selling – Short selling offers you the potential to profit in a down market by taking advantage of a declining stock price. By nature, short selling can be risky because you may end up buying back your short position at a higher price than you sold it for.
Many traders use short selling as a hedging strategy in attempt to protect a long position with an offsetting short position. By holding both a short and long position in the same security, you're attempting to manage the risk associated with the security and ensure that a move in either direction won't make or break your portfolio.
3. Optimizing Your Buying Power – Scottrade's house maintenance requirement is typically 30%, but we have higher requirements for certain securities based on the security's current trading price and volatility (see our Margin Requirements table). When you use margin to purchase securities with higher maintenance requirements, your buying power decreases as a result of the increased equity requirement for that particular security.
If you're trying to optimize your buying power, you'll need to be cognizant of the maintenance requirements for each purchase you make and how your purchases impact your buying power. For example, let's say you're interested in two different tech stocks – one trading at $7.50 per share (which has a 30% maintenance requirement) and the other trading at $3.25 per share (which has a 50% maintenance requirement).
If your goal is to increase your position in the technology sector and the stocks have similar characteristics, you may consider purchasing the one trading for $7.50 per share to keep a lower maintenance requirement and utilize more of your buying power.
You'll also need to be aware of the diversification of your account, since highly concentrated accounts may have a higher maintenance requirement. By continually optimizing your buying power, you may be able to trade a greater number of securities and increase your diversification, thus increasing your market exposure while attempting to manage risk.
4. Maximizing Your Buying Power – Another way to use leverage is to apply the full amount of your buying power to purchases. This strategy fully exposes you to the market and, as a result of your increased exposure, offers the possibility of increased returns as well as increased losses. When you use this strategy, it's important to realize that the decrease in the market value of a single position can decrease your equity below the minimum equity requirement and trigger a maintenance call.
Keep in mind that while diversification may help spread risk it does not assure a profit, or protect against loss, in a down market.
This article is for information purposes only and use of strategies does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security or account type before making an investment decision. Scottrade's margin agreement is available at scottrade.com, or through a Scottrade branch office, and contains the Margin Disclosure Statement and information on our lending policies, interest charges, and the risks associated with margin accounts.