The Power of Leverage

Investopedia defines leverage as “The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.”

” Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.”

Traders understand the power of leverage very well since it is the use of leverage that can provide above average returns to traders. But,leverage is a double edged sword.  Just, as it can provide above average returns, it can also provide rather quick destruction of trading capital.

On last Thursday, I had taken bullish positions in the Nifty, a position which was explained repeatedly over CNBC, so I will not go into the explanation. Most of the positions were in 5100 July calls. Some were in 5400 calls. As it happened, the 5400 calls were sold on Friday at more than double the cost. That’s leverage working in our favor. IF the market had opened even slightly lower, the calls could easily have become half of their cost. So, a 50% destruction of capital was possible, rather quickly.

The 5400 calls were only a percentage of the overall bullish position, and, we had to accept the real possibility that the calls could result in big losses. Hence, their volume was controlled.

My point is: As this up move continues, traders will find many opportunities of leveraging their trades to obtain larger gains. They should do it. But, understand the risk, always.