If you’re looking to boost your returns in the Indian stock market, leverage is a tool you need to know about. But be warned: it’s a powerful tool that can amplify both your profits and your losses.
In this blog post, we’ll explain how leverage works, its benefits and risks, and how to use it safely and effectively.
What is Leverage?
Leverage, in simple terms, refers to using borrowed capital or financial instruments to increase the potential return of an investment.
In the Indian stock market, investors can leverage their initial capital to buy more stocks or securities than they could with their own funds alone. This allows them to control larger positions with a relatively smaller amount of invested capital.
How Does Leverage Work in the Stock Market?
In the stock market, leverage operates through various financial instruments, such as margin trading which is provided by the broker or by using futures and options which are self-leveraged instruments.
These tools enable investors to borrow funds or enter into contracts that have the potential to generate larger profits or losses than the initial investment. By leveraging, investors can significantly enhance their purchasing power and potentially amplify gains.
Different Ways to Avail Leverage in the Indian Stock Market
There are different ways in which one can avail leverage in the stock market to initiate positions which exceed the funds you have in your trading account with the broker. Here are some of the ways in which you can avail leverage in Indian stock markets-
Margin trading is the most common way to avail leverage in the Indian stock market. It allows you to buy stocks by paying only a portion of the total value, known as the margin, while the broker provides the rest as a loan.
The margin requirement varies depending on the broker and the stock being traded. For example, a broker may require a margin of 50% for a large-cap stock, but a margin of 75% for a small-cap stock.
Let’s say you want to buy 100 shares of a stock that is trading at ₹100 per share. If you have a margin requirement of 50%, you will only need to pay ₹5,000 to buy the shares. The broker will provide the rest as a loan.
Using futures contracts is another way to avail leverage in the Indian stock market. A futures contract is an agreement to buy or sell an underlying asset at a predetermined price on a future date.
Futures contracts are traded on exchanges, and they are leveraged instruments. This means that you can control a large position in a futures contract with only a small amount of money.
Let’s say you want to buy a futures contract on the Nifty 50 index. The Nifty 50 index is a basket of the 50 largest and most liquid stocks on the National Stock Exchange of India. The margin requirement for a Nifty 50 futures contract is 10%. This means that you can control a futures contract worth ₹10 lakh with only a margin of ₹1 lakh.
Options contracts are another way to avail leverage in the Indian stock market. An options contract gives you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specified date.
Options contracts are traded on exchanges, and they are leveraged instruments. This means that you can control a large position in an options contract with only a small amount of money.
Let’s say you want to buy a call option on a stock that is trading at ₹100 per share. A call option gives you the right, but not the obligation, to buy the stock at a predetermined price on or before a specified date.
Let’s say the call option has a strike price of ₹110 and an expiry date of 3 months. The margin requirement for this call option is 10%. This means that you can control a call option worth ₹10 lakh with only a margin of ₹1 lakh.
How to use Leverage Effectively?
Here are some tips and tricks which you can use in order to make sure that you are using leverage in the most effective way for your trades.
Thorough Market Research
Before you use leverage to invest in the Indian stock market, it is important to conduct thorough market research and understand the risks involved. This includes understanding the following:
What are the overall market trends? Are there any specific sectors or industries that are performing well or poorly?
How have the stocks that you are interested in performing in the recent past? What are the analysts’ expectations for their future performance?
What are the specific risks associated with the stocks that you are interested in? This could include factors such as financial health, industry risks, and regulatory risks.
Let’s say you are interested in using leverage to invest in the Indian technology sector. You have done your research and found that the sector is expected to grow strongly in the coming year. You have also identified a few specific technology stocks that have been performing well and have good analyst ratings.
Based on this analysis you can initiate a position in the technology stock and exercise leverage to make the most out of the position.
Setting Realistic Goals
Once you have a good understanding of the market and the risks involved, you need to set realistic goals for your leveraged investments. It is important to remember that leverage can amplify both your profits and your losses. Therefore, it is important to set goals that are aligned with your risk appetite and investment objectives.
For example, if you are a risk-averse investor, you may want to set a goal of earning a modest return on your leverage investments, such as 10% per year. If you are a more risk-tolerant investor, you may want to set a more ambitious goal, such as 20% per year.
Risk management is essential when using leverage since you need to avoid any excessive losses on your open positions which might blow up your capital deployed in trading account. Here are a few risk management techniques that you can implement:
A stop-loss order is an order to sell a security when it reaches a certain price. This can help to limit your losses if the price of the security moves against you.
Position sizing refers to the amount of money that you invest in a particular security. It is important to size your positions carefully to avoid over-leveraging yourself.
Diversification is the process of investing in a variety of different assets to reduce your overall risk. This is especially important when using leverage, as it can help to mitigate your losses if one of your investments performs poorly.
Benefits of Using Leverage
Leverage offers the following benefits to investors and traders-
Increased Purchasing Power
Leverage allows investors to control more shares or securities than their initial capital would permit, thereby increasing their potential for profits.
Enhanced Portfolio Diversification
With leverage, investors can diversify their portfolios more extensively, spreading their risk across a wider range of assets.
Opportunity for Higher Returns
Leveraged investments can generate higher returns compared to unleveraged investments, provided the market moves in the desired direction.
Risks of Using Leverage
Just as leverage amplifies gains, it also magnifies losses. If the market moves against the investor’s position, the losses can surpass the initially invested capital.
Borrowed funds typically come with interest costs, which can eat into profits and potentially lead to substantial losses.
In cases where the value of the leveraged position falls significantly, brokers may issue margin calls, requiring investors to deposit additional funds to cover potential losses or risk the position being closed out.
In conclusion, leveraging in the Indian stock market can be a powerful tool if used prudently and with a comprehensive understanding of its associated risks. Investors must approach leveraging with caution, conducting thorough research and implementing effective risk management strategies to ensure a balanced and informed investment approach.
Leverage can significantly increase both the potential gains and losses in an investment portfolio. Retail investors can maintain a balanced risk-reward ratio by diversifying their investments, setting stop-loss orders, conducting thorough market research, and adopting a disciplined investment approach.
Using leverage for short-term trading can potentially amplify gains but also increase risks, while long-term investing with leverage can result in magnified returns over time, but with a higher exposure to market fluctuations. Investors should assess their risk tolerance and investment goals before deciding on their preferred approach.
Retail investors can assess their risk tolerance by evaluating their financial goals, investment experience, and ability to withstand market fluctuations. Before incorporating leveraged investments, they should consider factors such as market volatility, financial stability, and the potential impact of interest rates on their investments.
Leveraged investments in the Indian stock market may have tax implications, including tax deductions on interest payments and capital gains tax on profits. It is advisable for investors to consult with tax advisors to understand the tax implications and optimize their investment strategies accordingly.
Best practices for using leverage responsibly include conducting thorough market research, understanding the risks involved, setting realistic investment goals, implementing effective risk management strategies, and continuously monitoring market trends. It is essential for retail investors to seek guidance from financial advisors and educate themselves about the intricacies of leveraging before engaging in leveraged investments.