Using Leverage in the Stock Market: The Good, The Bad & The Ugly

Using borrowed money to buy an asset isn’t something that uncommon in financial markets. If you own a home – chances are, you’ve borrowed money from the bank in the form of a mortgage. In the example you’ve put down a 20% deposit to buy your first home and the bank is covering the other 80%, effectively you’re working with what is 5x leverage. Much the same can be emulated in the stock market via the use of Contracts for Difference (CFD’s) or a margin lending facility on shares. Investors use these kinds of features to gear up their investment to amplify their potential returns. The challenge is that the stock market is a lot more volatile than the property market, so you’re much more likely to see large swings in the value of your positions. At times throughout my near 30-year career, I’ve seen some pretty ugly situations stem from some bad use of leverage. Check out one of our podcast episodes on the Money and Investing show, episode 46 in 2021, as I talk to this in great detail.

Notwithstanding the above comments, I’ve also seen some people make an absolute killing using borrowed funds in the stock market. When trading a leveraged asset on the stock market, the good news is that if the trade goes your way – you’ll make x times as much money, being whatever the leverage factor is. Get this right a couple of times and you’re laughing – for a small amount of capital, you’ve been able to turn water into wine using borrowed funds.

This all sounds pretty good, right? Yes, it does, until you factor in the risks of doing so. When using CFD’s or a margin lending facility in the share market, knowing that by gearing up on your money, your risk is amplified if that investment were to take a downturn. Often in these instances, the investor can be forced to pour in more money in order to satisfy the loan to value ratio on that particular asset, just to avoid having their investment liquidated by the lender. If you don’t have that cash available to top up the investment, the lender has the right to retrieve that equity by any means possible – which may mean administration of your assets. Yes, the potential return of a leveraged investment is attractive, albeit understanding the wicked risks first is paramount. I’ve seen some clients of mine in the Foreign Exchange and CFD’s space completely blow up their accounts in just a matter of weeks by gearing up way too hard.

Considering all of the above, any prospective leverage user can see that the returns are attractive, albeit the risks are not. To those people I would say one word – options. Financial options are something I have traded for the last 27 years and taught globally to thousands of people via Australian Investment Education for nearly 15 years now. Financial options, being a derivative asset, offer a complex range of uses when trading the stock market – speculation hedging, income, and you guessed it – leverage. In particular, my Options Mastery program teaches how to gear up your investments safely by having a pre-defined level of risk on the trade. For those working with a small amount of capital, this is awesome as they can have the leverage upside without the worry of blowing up their account. Join me at one of my seminars at the following link to see how this is possible: http://bit.ly/aie-mjb

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