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Chapter 2 Leverage

Leverage is the ability to trade a large position (i.e. a large number of shares or contracts) with only a small amount of trading capital (i.e. margin). Leverage can also be defined as the use of borrowed money to increase returns. Professional traders extensively make use of leverage to magnify their returns from relatively small price changes in the underlying security.

The process of borrowing works differently in different markets. When you place an order in the cash market, you have the facility to select margin products. Most large brokers provide margin products which give clients leverage up to 5-10 times of the allocated trading amount for intraday trades, while in the derivatives market, the contracts that you trade have leverage built into them.

Leverage is commonly believed to be of high risk because it supposedly magnifies the potential profit or loss that a trade can make.

Let us understand leverage with an example:

Consider a trader has a bullish view on Reliance Industries and has Rs.2,50,000 in capital available with him. He can consider buying the stock in the cash market, purchase a margin product which offers 5x leverage, purchase a futures contract, or buy a call option. Since margin products are offered for intraday trades, we will restrict the example to a single session and assume that the price in spot and futures market is the same.

The price of Reliance Industries is Rs.900 on March 8, 2018, when he makes the transaction. He sells his position the same day when the stock hits a price of Rs.914, netting a gain of Rs.14 per share.

We now analyze the profit that the client stands to earn in each of the four segments and the impact leverage has on the return ratios.

a) Cash (Spot Market)
Shares purchased = 2,50,000/900 = 277
Profit earned = 277*14 (gain per share) = Rs.3,878
Percentage returns = 3,878/2,50,000 =1.55%

b) Margin product (5x leverage)
Margin funds available = 2,50,000*5= Rs.12,50,000
Shares purchased = 12,50,000/900 = 1,388
Profit earned = 1388*14 (gain per share) = Rs.19,432
Percentage returns = 19,432/2,50,000 = 7.77%

c) Futures
Lot size of Reliance Industries = 1,000 shares
Contract value per lot = 900*1,000 = Rs.9,00,000
Margin required to purchase one lot = 13%
Margin deposited to purchase lot = 900000*0.13 = Rs.1,17,000
No. of lots that can be purchased = 2,50,000/1,17,000 = 2
No. of shares purchased = 1,000*2 (one lot = 1,000 shares) = 2,000 shares
Profit earned = 2,000*14= Rs.28,000
Percentage returns = 28,000/2,50,000 = 11.2%

d) Options
Lot size of Reliance Industries = 1,000 shares
Price of 900CE option when price of stock was at 900 on March 8 = Rs.21
Cost to purchase one 900CE option = 21*1,000 = Rs.21,000
Number of 900CE options that can be purchased = 2,50,000/21,000 = 11
Profit earned in one 900CE option as price moved from 900 to 914 = Rs.4
Profit earned = 11 (no. of contracts)*1,000 (lot size)*4 (profit per lot) = Rs.44,000
Percentage returns = 44,000/2,50,000 = 17.6%

Capital available Rs.2,50,000
Stock purchased Reliance @900
Segment Profit earned
Cash 1.55%
Margin Trading 7.77%
Futures 11.2%
Options 17.6%

From the above example, we clearly see the benefits that leverage tends to add to the returns. The client makes the maximum profit while trading in options compared to other segments, as it offers the highest leverage. With Rs.2,50,000 in capital, the client is able to purchase 4,000 shares (four lots of thousand shares each) in the options segment compared to 277 shares in the cash market where there is no leverage benefit.

Risk while trading with leverage

If the trader does not get his view right and trades without a stop loss, then things might get risky. Stop loss is one of the primary tools that is used while trading in the derivatives segment or while trading margin products, else the chances of facing losses are quite high.

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