Leverage is a controversial subject in the trading world. Traditional investing advice discourages the use of margin. You hear stories of traders going into debt to their broker because of it, and many other negative things on the mainstream financial news.
These things are true, but it can also be an effective tool to exponentially grow your trading account in a short period of time. It can either be your best friend or your worst enemy. In order to reap the benefits of margin, you must understand what it is and when to use it. Before talking about how to use margin, let’s start by defining what it is:
What is Margin?
Margin, also referred to as leverage, is defined as the ability to increase the size of your investment by using credit from a broker. Many brokers offer 4:1, sometimes up to 6:1, leverage on your trading positions. This means that if you have a $5k trading account, you will have up to $20K in buying power if your broker gives you 4:1 margin on your trading account. Margin has the potential to make your winners a lot bigger, but also your losers a lot worse.
Focus on Trade Risk
Risk management is a crucial concept to understand in order to use margin properly. Since you are actually borrowing money from your broker, you need to obey your stop losses otherwise you risk going into debt with your broker. When your trading using margin, focus on how much money you are risking per trade, and buy or short that many shares of a stock accordingly.
For example, let’s say you want to buy TSLA at $300, put your stop loss at $295, and you want to risk $250 on the trade. This would mean you would buy 50 shares of TSLA for this trade. If you own 50 shares of TSLA at an average cost of $300 per share, you would lose $250 if the stock dropped $5 per share in value. The transaction costs $15K to do, but your are only risking $250.
Able To Trade Higher Priced Momentum Stocks
You can see in the example above that one of the biggest benefits of margin is that it allows traders with smaller accounts to trade and profit from higher priced momentum stocks. TSLA is good example of higher priced momentum stocks, and it’s shares are relatively expensive. This is when margin comes in handy.
For the trade mentioned above, you will need to have $15,000 in capital in order to make the trade. If you only have a $10K trading account, you would not be able to make this trade and risk what you want to unless you used margin. If you use margin from your broker, you will be able to make this trade, and still only risk $250 of your trading account.
Everyone Has Different Risk Tolerance
When you are figuring out trade risk, you should consider the context of the trade in your overall finances, not necessarily a percentage of your account you are risking. If you have $500,000 in savings and you have a $5K trading account, it is not necessarily considered reckless to risk $500 of that money per trade. That $500 dollars will not change your life if you lose it. It is not necessarily considered reckless if this trader used margin on their account, even though they are risking 10% of their account.
However if you only have $2K in savings and a $5K trading account and you are risking $500 on a trade, you are being reckless. If you are risking this much of your net worth on each trade you will likely become very emotional, and not make correct trading decisions. Do not use margin to risk a huge portion of your net worth on a trade because you want to get rich overnight. That is a gambler’s mentality, and this mentality will never lead to a successful trading career.
Exponential Account Growth
One of the biggest benefits of margin is that it allows you to turn a small amount of capital into larger quantity in a short period of time. Assuming you have the correct trading system, risk management, and trading psychology, margin will allow you to exponentially grow a small amount of money into a larger amount.
Going back to the TSLA trade example above: If you have a $5K trading account and you want to buy 50 shares of TSLA at $300, you have to use margin to complete the transaction cause it costs $15K. Your stop loss is still at $295 so you are risking $250. However if TSLA goes to $310 and you sell, you make $500, which is a 10% gain on your account.
If you made 3 trades like this a week, and let’s say two of them are winners and one of them is a loser to be realistic. You would make $750 a week (two $500 winners and one $250 loser), and around $3K a month. You would be able to double your trading account in just two months. This is the power of margin (if used correctly).
*Please keep in mind using margin can be dangerous and you are at risk to lose more then whats in your account. Use it with extreme caution.
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