As a stock trader, you hear the word leverage thrown around a lot. But what does it mean? What is leverage, and how can you use it to your advantage?
For those new to trading, leverage is when an investor uses borrowed money to invest, which can magnify gains or losses. This works well for aggressive investors who want more bang for their buck but are willing to take on more risk. Here are five tips to take advantage of leverage as a trader.
1. Know Your Capital Requirements
If you’ve ever had a mortgage and gotten a home equity line of credit, you might also have borrowed money to invest and use leverage. You may have also dealt with margin calls or having your broker ask you to put up more cash when the value of the investment drops below what you borrowed.
To avoid margin calls, you should know your capital requirements before buying a stock that uses leverage. Each brokerage firm has rules and regulations regarding how much collateral they require before investing on margin.
For example, if you buy a stock using 10:1 leverage, you will need $10 in your account to purchase $100 in stock. Conversely, if the value of the stock falls 5% and is valued at $95 per share, you now have a pre-set margin trigger of 5% or $5. If that happens, your broker will automatically sell the stock to reduce your debt to the required amount. Get comfortable working with at least 20% of your portfolio on margin if possible.
2. Avoid Penny Stocks
Penny stocks can be a great place to start if you don’t have much experience in the market. They are cheap, so you’ll be able to buy a lot of shares for a small price. However, penny stocks are some riskiest investments and can quickly become losses due to investor panic, volatility, or serious mismanagement. To avoid paying too much for shares of an unknown company, you should look at past earnings reports and how the CEO is running things. The SEC also publishes tips on how to invest in penny stocks.
3. Use Order Flow Trading Strategy
If you can predict panic and volatility in the market, you can use order flow trading to your advantage when it comes to leverage. You can buy stocks that have huge orders flowing into them from other traders. Buy a stock that is being heavily bid up and sell a stock that is being heavily sold for the same amount later. Order flow trading works well if you know the difference between the supply and demand for a stock.
Once you understand how order flow trading works, use it to your advantage by becoming a market maker. You can consider getting professional order flow training online or attending a course offered by your brokerage firm.
4. Know How to Take Profits
Because leverage magnifies gains and losses, you must plan to take profits when they occur. Just as with leverage trading, you want to be prepared to sell shares of a stock if it starts moving in the wrong direction during the down cycle.
Use technical indicators to predict where the stock will go next. You can also use price action to determine support and resistance levels to make a more informed decision.
Once you’ve determined how much capital you want to put into stock and the reward potential, plan to monitor your losses and exits. To protect profits, you may end up exiting a stock before it becomes a loss by taking out any short-term gains you may have made.
If the trade goes in your favor and you want to increase your gains, consider taking partial profits at different stages of an upward trend.
5. Buy Different Stocks
Use different stock positions to manage risk. This can help you develop a diversified portfolio without adding too much volatile risk. If you are new to trading, look for stocks with low debt, high dividend yield, and good earnings that increase over the long term.
Also, consider using a technical indicator or charting software as a form of control to reduce the risks of losing money. You can monitor your profits and losses and position sizes and stop losses in real-time on your mobile devices.
When used properly, leverage is a useful tool for stock traders to maximize trades. Some investors use leverage as a strategy that increases risk, while others use it to reduce the amount of money they keep in their trading accounts. Be sure to learn how leverage works before investing and make sure that you know the risks of margin trading before making a trade.