{"id":2333,"date":"2021-06-30T04:34:26","date_gmt":"2021-06-30T04:34:26","guid":{"rendered":"https:\/\/www.paytmmoney.com\/blog\/?p=2333"},"modified":"2021-06-30T04:34:26","modified_gmt":"2021-06-30T04:34:26","slug":"leverage-stockmarket","status":"publish","type":"post","link":"https:\/\/www.paytmmoney.com\/blog\/leverage-stockmarket\/","title":{"rendered":"Leverage \u2013 A Double-Edged Sword"},"content":{"rendered":"

Here\u2019s an explainer on how leverage works in the equity and derivatives market.
\nLet\u2019s start with the basics.<\/p>\n

What is Leverage?<\/h2>\n

Leverage refers to a mechanical advantage which amplifies a small input force to achieve greater output in physics. Financial leverage follows the very same principle. It amplifies an investor\u2019s buying power in the market.
\nTrading that employs leverage is called leverage trading. Leverage trading refers to the use of borrowed capital to get much higher potential return on your investment. It allows you to open positions that are much larger than what your original capital would allow you otherwise.<\/p>\n

The idea here is to borrow capital to buy more contracts of an asset expecting that the position\u2019s returns would be greater than the cost of borrowing.<\/p>\n

SBIN Example
\nLet us take the example of State Bank of India (SBIN) to understand leverage trading and non-leverage trading in detail. Let the spot price and July futures contract price be the same at Rs. 420. Let us also assume that we have Rs.2,30,000 at our disposal. We have two options to pick from.<\/p>\n

Option 1: Buy SBIN stock in the equity market
\nOption 2: Buy SBIN futures in the derivatives market<\/p>\n

Let us understand each option in detail.<\/p>\n

Option 1: Buy SBIN stock in the equity market<\/h2>\n

a. When SBIN goes to Rs. 450<\/h3>\n

Buying SBIN requires us to check the price of SBIN in the market and also the number of stocks we can buy with Rs. 2,30,000.
\nWith Rs. 2,30,000 at our disposal, we can buy Rs.2,30,000\/Rs. 420 = 547 stocks. And when SBIN is trading at Rs. 450 we can square off the position for a profit.<\/p>\n

Amount received = 547 * Rs. 450 = Rs. 2,46,150
\nAmount required to buy 547 stocks = 547 * Rs. 420 = Rs. 2,29,740
\nProfit = Rs. 2,46,150 \u2013 Rs. 2,29,740 = Rs.16,410
\nLet us calculate the return = (Rs. 16,410\/Rs. 2,29,740) * 100 = 7.14%<\/p>\n

b. When SBIN goes to Rs. 390<\/h3>\n

Let us now see what happens if the price goes down to Rs. 390.
\nAmount received = 547 * Rs. 390 = Rs. 2,13,330
\nLoss = Rs. 2,29,740 \u2013 Rs.2,13,330 = Rs. 16,410
\nLoss % = (Rs. 16,410\/2,29,740) * 100 = 7.14%
\nLet us now see option 2<\/p>\n

Option 2: Buy SBIN stock in the futures market<\/h2>\n

a. When SBIN goes to Rs. 450<\/h3>\n

Let the lot size be 1500. This means the number of stocks that must be bought is 1500 or a multiple of 1500.
\nThe futures price is Rs. 420.
\nTherefore, the contract value is = Rs. 420 * 1500 = Rs. 6,30,000<\/p>\n

Let us say that the margin is about 35%. So, to enter into the contract, we need to provide =
\n35% * Rs. 6,30,000= Rs. 2,20,500<\/p>\n

This means that we can buy 1 lot of SBIN futures for Rs. 2,20,500.
\nFutures contract value at the time of selling = 1500 * 1 * Rs. 450 = Rs. 6,75,000<\/p>\n

This means a profit of = Rs. 6,75,000 \u2013 Rs. 6,30,000 = Rs. 45,000
\nA move from Rs. 420 to Rs. 450 made a profit of Rs. 16,150 in the spot market but a profit of Rs. 45,000 in the futures market.
\nLet us remember that investment for the futures trade is Rs. 2,20,500. Therefore, the return should be calculated keeping this as the base.
\n(Rs. 45,000 \/ Rs. 2,20,500) * 100 = 20.408%<\/p>\n

b. When SBIN goes to Rs. 390<\/h3>\n

Let us now assume that the price goes down to Rs. 390
\nFutures contract value at the time of selling = 1500 * 1 * Rs. 390 = Rs. 5,85,000
\nThis means a loss of = Rs. 6,30,000 \u2013 Rs.5,85,000 = Rs. 45,000
\nLoss % = (Rs. 45,000\/Rs. 2,20,500) * 100 = 20.408<\/p>\n

From the above examples, it is clear that leverage is a double-edged sword. While it increases the profit potential, it also increases the loss potential as can be seen in the examples above.
\nThe table below shows how return % in the case of futures is more compared to the case of equity for the same price movement.<\/p>\n

In Rs.<\/p>\n

\"leverage<\/p>\n

Now let us explore some of the advantages and disadvantages of leverage trading.<\/p>\n

Advantages:<\/h2>\n