“Give me but a firm spot on which to stand, and I shall move the earth.”
– Archimedes, Physicist of Ancient Greek
For investors, leverage is the “firm spot”. With a lever you can lift anything, provided the spot is firm enough.
In the market, it is common to “throw a sprat to catch a herring”.
Take housing mortgages as an example: for a USD1 million house, the buyer makes an USD100,000 down payment, and borrows USD 900,000 from the bank and pays interest for bank loans.
Similarly, a company with insufficient capital may choose to use borrowed capital for production, so as to boost its returns. However, this also increases the risks – in case the business was not performing as well as planned, the company will end up having more debts than assets.
To put it simply, “leverage is the use of debt (borrowed capital) for your own business”. Leverage can be realized by borrowing or derivatives.
When to use leverage?
Likewise, in the stock market, when you do not have enough money to buy USD50,000 worth of equity, leverage may offer a practical option.
Suppose we want to buy Stock A with a minimum lot size of $500, but we only have $100. What should we do?
We could use leverage.
5X leverage: $100 x 5 = $500. Thus, we can buy $500 worth of stock with only $100.
10X leverage: $100 x 10 = $1,000. Thus, we can buy $1,000 worth of stock with only $100.
It may occur to you that you can use higher leverage to buy the same shares with less capital.
$100 with 10X leverage: $100 x 10 = $1,000
$50 with 20X leverage: $50 x 20 = $1,000
Trading fee and interest paid/received are decided by the notional amount in derivatives contract trading. As we are trading $1,000 anyways, we are paying the same fee and interest. Why don’t we use higher leverage and pay less margin? If the price of Stock A goes up as you expected, congratulations! You made a good deal! However, if the price goes down otherwise, high leverage comes with accelerated liquidation. Liquidation means all money in your account will be lost.
If leverage is not used in trading, even when the share price plummets from $100 to $1, you can still get your $1 back by selling the shares or continue to hold it.
In leveraged trading, when your position margin declines to maintenance margin threshold, you will get margin call or be liquidated. To avoid liquidation, you may use lower leverage. From the second example we can see the lower the leverage, the higher the amount of margin are required and more buffer from liquidation.
What are the differences between levered and unlevered trading?
Suppose we have $8,000, and the last traded price of BTC is $8,000.
Upward: BTC price goes up to $8,050 the next day. We have two options:
Unlevered: Buy 1 BTC contract at $8,000. And take $50 gains by selling it at $8,050.
Levered: Buy $80,000 worth of contract at $8,000. And sell them at $8,050; as we are trading with 10x leverage, the gains are amplified by 10 times, i.e. $500.
(Multiple leverages provided by Bybit)
Downward: BTC price goes down to $7,950 the next day. We have two options:
Unlevered: Buy 1 BTC contract for $8,000. And lose $50 by selling it at $7,950.
Levered: Buy $80,000 worth of contract at $8,000. And sell them at $7,950; as we are trading with 10x leverage, the losses are amplified 10 times, i.e. $500.
From the above example we can see the leverage amplifies both gains and losses by 10 times.
Therefore, leverage is a double-edged sword – while your investment is augmented, so is your risk. The use of leverage can be satisfying if the market moves as expected, but the reverse is also true if it doesn’t!