Imagine the following scenario. You go to a bank, looking to obtain a loan so that you can purchase that shiny new car you've been eyeing for months. Interest rates are high, so you are bracing yourself for the worse. After doing a thorough background check on your finances, the banker gets back to you. You're anxious to know what kind of a loan you will receive, and at what interest rate the bank will charge you.
"Zero percent interest".
Sounds too good to be true? It is. You, and I, and the entire world knows that a bank will practically never offer a loan at zero percent interest. But what if there was a way to "borrow" money to purchase a product and hold it for weeks at a time? Does it sound too good to be true?
Well, it is true. Welcome to the crazy world of derivatives trading in the financial markets, where the terms leverage, exposure, and margin are most important to some traders than the broker that they trade through. In this article, we will caution you on the pitfalls of high exposure/leverage and how to (if you opt to) properly utilize leverage when trading Futures and Options.
What is leverage?
The terms leverage, exposure, and margin are all used interchangeably. One can state that they are getting "five times" exposure; another might state that he is getting 20% margin; and another might state that he is getting 5x leverage. All statements mean the same thing.
Leverage is actually is very simple concept to understand. In essence, instead of having to put up, say, 1 lakh rupees to purchase 100 shares of Reliance shares at a price of, say, Rs. 1000- a broker can offer you leverage and provide you the ability to only pay up a fraction of the amount. In equities/share trading, this concept is known as intraday trading and the "margin" amount is only applicable for trades done where the purchase and sell of the shares happens within the same day. In other words, you need to close your position by the end of the day. For example, suppose your broker offered you "5 times" exposure for intraday trading on equities; with the Reliance example, you would only have to fork up Rs. 20,000 instead of the entire 1 lakh.
In Futures and Options, which are Derivatives products, leverage is frequently provided by brokers. And since F&O (short for Futures and Options) are very popular in India, it is almost unheard of for a broker to not offer leverage. In fact, many traders make the mistake of overlooking critical factors and instead look for brokers offering the highest margin rates. This is a recipe for disaster.
The key to utilizing leverage responsibly is in actuality quite simple: never utilize leverage if it's not required. Many mistakenly look at leverage as a way to "purchase" an asset at a discount; in actuality, you're shooting yourself in the foot if you have the funds to purchase the asset but instead decide to utilize leverage. The reason has to do with the fact that with leverage, the chances of your trade to go against you and force your broker to issue a margin call goes up. Let's take the Reliance example again. Suppose you utilize the entire 5x leverage that your broker is offering you and purchase 100 shares of Reliance at a price of Rs. 100 by only putting up Rs. 20,000. Your trade value is 1 lakh; but if the price of Reliance falls from Rs. 100 to, say, Rs. 95- just a 5% fall- you are now Rs. 5000 in loss (Rs. 5 x 1000 shares). That's 25% of the amount you put up!
Prices fluctuate 5-10% all the time. But when this type of occasion occurs, two events happen: your emotions are going to inevitably be unstable, and your broker might ask you to fork up more money. If Reliance prices keep falling, your broker might even forcibly close your trade.
The key take away with leverage is this: don't use it unless you absolutely need it. That's how you trade responsibly, and in the long run, beat the markets.