Should You Use Leverage to Buy Stocks?

Leverage is like a double-edged sword in the world of stock trading. It can amplify your gains, but it can equally magnify your losses, leaving you in financial ruin if not handled properly. However, there are savvy ways to use leverage responsibly, and if done correctly, it could propel your portfolio to the next level. But is it worth the risk? Let’s dive in.

Imagine this: You’ve identified a stock that you believe is undervalued. You’re confident that it’s going to skyrocket in value, but you only have $10,000 available to invest. Using leverage, you borrow an additional $10,000, giving you a total of $20,000 to invest. If the stock increases by 10%, your profit isn’t just 10% on your original $10,000. It’s 10% on the full $20,000, which means you make $2,000 instead of $1,000. That sounds pretty sweet, right?

But now picture the downside: if the stock drops by 10%, you don’t just lose $1,000—you lose $2,000. That’s 20% of your original capital gone in one swoop. The leverage that worked in your favor when things were going well is now working against you. And it doesn’t stop there. Since you borrowed that $10,000, you now owe interest on it, compounding your losses.

Why Some Investors Use Leverage

So, why would anyone use leverage if it’s so risky? The simple answer: potential for higher returns. Some investors are willing to take on the extra risk for the chance of doubling or even tripling their profits in a shorter period. Leverage gives you the ability to control a larger amount of stock without having the full capital upfront.

Professional traders and institutional investors often use leverage as part of their strategies because they have the experience, resources, and risk management tools to handle it. Retail investors, however, should be cautious. The stock market can be unpredictable, and without proper knowledge and strategy, the average person could lose everything.

The Importance of Risk Management

Leverage isn’t necessarily a bad tool, but like any powerful instrument, it requires caution and expertise. Risk management is critical when using leverage in stock trading. Here are a few ways to protect yourself:

1. Set stop-loss orders: A stop-loss order is a predetermined price at which your stock will be sold automatically. This helps minimize losses by exiting the trade when the stock hits a certain price.

2. Limit the amount of leverage used: Instead of using the maximum amount of leverage available, use a smaller percentage. This limits the size of your losses.

3. Diversify your portfolio: Don’t put all your eggs in one basket. By spreading your investments across different sectors or assets, you reduce the risk of one trade wiping you out.

4. Stay informed: Keep up with market trends, earnings reports, and global economic indicators. The more you know, the better prepared you’ll be to make informed decisions.

The Hidden Costs of Using Leverage

Interest payments: Borrowing money isn’t free. Most brokers charge interest on the amount you borrow to trade on margin. This can eat into your profits or even increase your losses.

Margin calls: If your account balance falls below a certain level, your broker will issue a margin call, demanding that you deposit more funds to cover your position. If you can’t, they’ll start selling off your assets to cover the loss, potentially at a loss.

When Leverage Works Best

Leverage can be beneficial in a rising market or during short-term price swings when you're confident about your stock’s trajectory. But remember, no one can predict the market with 100% certainty.

Take for example the case of Tesla. During its meteoric rise in 2020, investors who used leverage saw exponential gains. But the reverse is also true. In times of uncertainty or market downturns, like during the 2008 financial crisis, leverage caused many investors to lose their entire portfolios.

A study from the Financial Industry Regulatory Authority (FINRA) revealed that nearly 90% of retail investors who used leverage lost money, primarily because they lacked proper risk management techniques.

Leverage and Your Investment Goals

Before using leverage, ask yourself a few critical questions:

1. What are your investment goals?
2. Are you investing for the short term or the long term?
3. Can you afford to lose the capital you’re risking?
4. Do you have a plan for managing your risk?

If your goal is long-term wealth accumulation, you might not need leverage at all. Many successful investors, like Warren Buffett, rarely use leverage, instead relying on the power of compound interest and steady, conservative investing.

On the other hand, if you’re a short-term trader looking to capitalize on small price movements, leverage might offer a way to increase your returns. But be prepared to lose as quickly as you win.

A Better Alternative: Gradual Wealth Building

Rather than risking your financial future on leveraged trades, consider a more conservative approach: gradually building wealth through regular contributions to a diversified portfolio.

This might not be as exciting as the thrill of leveraged trades, but it’s a proven strategy for long-term success. The stock market has historically provided returns of around 7-8% annually. Over time, these returns can add up significantly, thanks to the power of compounding.

The Final Verdict: Should You Use Leverage?

Ultimately, whether or not to use leverage depends on your risk tolerance, your knowledge of the stock market, and your investment goals. If you’re a seasoned investor with a solid risk management strategy, leverage can be a powerful tool. But for most retail investors, the risks outweigh the rewards.

In a world where market volatility is increasing and economic uncertainties loom large, it may be wiser to play it safe and invest only what you can afford to lose. Leverage isn’t a shortcut to wealth—it’s a calculated risk that can either accelerate your gains or devastate your finances.