Using leverage can help your trading risk management.

A Leveraged Approach to Managing Risk and Reward

Outside of the financial world, leverage simply means using a relatively small force to gain access or control over something else. Most people use leverage when buying a house. And from politics to engineering, leverage is well-known and practiced.

In the financial world, leverage basically means using a small portion of your money to gain control over a potentially larger position. On the upside, leverage can boost profit and possibly help you diversify your investments; on the downside, leverage can multiply losses. That’s why leverage needs to be used only as part of a well-understood trading plan, and you need to understand the risks involved.

Types of Leverage

  • Margin trading. Margin allows you to use your securities as collateral for additional buying power. For example, if you own 100 shares of a stock selling for $50 per share, you could potentially use that $5,000 position to buy more shares of that security, or another security, without additional upfront cash. Of course, buying on margin increases your risk, as well as your potential for loss.
  • Options trading. With options, you can gain exposure to the underlying securities for a fraction of the actual market price. For example, if you have $500 to invest, you could buy 10 shares of a stock selling for $50 a share. Or, for the same amount, you could get exposure to many times more shares by purchasing options contracts. For those of you unfamiliar with options, purchasing a call option contract gives the owner the right to buy an underlying security at a specific price and date. Purchasing a put option contract gives the owner the right to sell an underlying security at a specific price and date. In both cases, the holder of the option pays a premium to purchase the option, and the maximum potential loss is the premium.
  • Leveraged Exchange-Traded Fund. A leveraged ETF magnifies exposure to an index (such as the S&P 500) by a multiple of two to three times. So a $1 move in an index can translate into a $3 move (up or down) for a 3X leveraged ETF. You should pay careful attention to the “down” potential of leveraged ETFs.  Leveraged ETFs have unique risks discussed in detail in their prospectuses. 

Ups and Downs of Leverage

  • The Upside. Because of the increased exposure, your profit could increase faster than the security rises. You also can use leverage to help diversify your portfolio with a lower initial investment
  • The Downside.  Potential losses are magnified just like gains. There is potential to lose more than what you originally allocated to the trade. In addition, when you’re borrowing money from the brokerage, you have to pay interest which can reduce profits and add to losses.

Read Next: You Know Risk and Volatility, But Can You Measure Them? 

Investors should consider the investment objectives, charges, expense, and unique risk profile of an exchange-traded fund (ETF) before investing. A prospectus contains this and other information about the fund and may be obtained online or by contacting Scottrade.  The prospectus should be read carefully before investing.

Leveraged and inverse ETFs may not be suitable for all investors and may increase exposure to volatility through the use of leverage, short sales of securities, derivatives and other complex investment strategies. These funds’ performance will likely be significantly different than their benchmark over periods of more than one day, and their performance over time may in fact trend opposite of their benchmark. Investors should monitor these holdings, consistent with their strategies, as frequently as daily. 

Diversification may help spread risk, but it does not assure a profit, or protect against loss, in a down market.

All investing involves risk. The value of your investment may fluctuate over time, and you may gain or lose money.

Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade’s margin agreement is available online or by contacting Scottrade, and contains the Margin Disclosure Statement and information on our lending policies, interest charges, and the risks associated with margin accounts.

Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade® Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy by contacting Scottrade. Supporting documentation for any claims will be supplied upon request. 

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

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