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) carefully before investing. The prospectus contains this and other information and should be read carefully before investing.  An ETF prospectus must be obtained from the issuer.

Leveraged 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.

Keep in mind that while diversification may help spread risk it does not assure a profit, or protect against loss, in a down market.

All investing involves risk. The value of your investment will 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 at scottrade.com, or through a Scottrade branch office, 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 Scottrade's Options Application and Agreement, Brokerage Account Agreement, and by downloading the Characteristics and Risks of Standardized Options booklet. You can also order a copy of the booklet by phone at 1-888-OPTIONS or obtain a copy at a Scottrade branch office. Market volatility, volume, and system availability may impact account access and trade execution.  Consult with your tax advisor for information on how taxes may affect the outcome of these strategies.  Keep in mind profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.

The material provided in this presentation is for informational purposes only and its use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security, type of security, or pursue a specific strategy. Investors should fully research any security or strategy before making an investment decision. Market volatility, volume, and system availability may impact account access and trade execution.

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