In equity markets, there is a complex structured product known as derivatives that derive its value from the underlying asset. This underlying asset could be an index or a stock. Derivatives are further sub-classified into 4 subtypes that are: Swaps, Futures, Options, and Forwards, etc. Before explaining the advantages and disadvantages of leverage, we should first get to know these products and the meaning of leverage. Out of the aforementioned 4 types of derivatives, Futures and Options (F&O) are the most actively traded derivatives. This is because they are traded on stock exchanges, unlike Forward contracts that are over the counter (OTC) products. Leverage helps you to take a big position in the F&O trades, but there are multiple pros and cons of leverage that we will explain in this article. To know that, we need to first understand what Futures and Options (F&O) are. Let’s get started:
What are Futures and Options (F&O)?
Futures are contracts that give the buyer a right to buy or sell the security at a predetermined price on a pre-decided date, it is an obligation. However, options give the buyer a right, not an obligation to buy or sell the security at a predetermined amount on a specific date. Options are of two types: Call options and Put options. The former is taken when you are expecting the stock or index to go up, and the latter is taken when you are expecting the index or the stock to fall. Leverage is a way out to take bigger positions in an F&O trade as trading capital requirements here are huge. However, there are pros and cons of financial leverage as well that are explained below. But, before that, let’s first get to know what leverage as a term means. Here it goes:
What is Leverage?
Leverage can be explained as buying or short selling shares of an amount more than what you have in your trading or Demat account. It is usually the ratio of the actual amount available for trading in your Demat account to the ceiling amount limit with which you can trade. The extent to which you can trade can be anywhere between 5 times to 100 times the capital available in your Demat account. For instance: If you have Rs.100 in your trading account, then you can take a position up to Rs.500 to Rs.10,000 in F&O. This might seem lucrative from the outset, but there are many advantages and disadvantages of leverage. In simple terms, leverage can be thought of as an overdraft (OD) facility for trading. This facility is offered by the stockbroker who is managing your portfolio by executing buy and sell decisions on your demand.
Concept of Margin Trading
Trading on margins or margin trading is related to leverage with a small difference that it is the percentage of the deposit amount needed for entering a trade. For instance: In an Rs.100 trade, a 5% margin requirement essentially translates to having Rs.5 as a security amount deposited with the broker. To draw a correlation, 5% margin requirement is tantamount to 20 times leverage, likewise, 20% margin requirement means 5 times leverage is given by the broker. The margin percentage is determined by the frequency and volume of trades from your Demat account. In a nutshell, both leverage and margin trading involves taking positions in the market in the F&O segment by borrowing money from your broker.
Pros and Cons of Leverage
By now, you must have got a sense of what the F&O segment in derivatives is all about and what margin trading and leverage mean. In this section, we will highlight some of the advantages and disadvantages of leverage in F&O trading while taking a position in the market. Here it goes:
Advantages of Leverage
Some of the notable advantages of taking the leverage options are as follows:
1. Less Capital Required:
One of the main advantages of leverage is that you can take bigger positions in the market, even if you don’t have a sufficient amount of money. It gives you the probability to make more profits if the trade goes as per your expectations. Thus, even if you don’t have a large trading capital with you, you can still trade.
2. Higher Profits:
Leverage gives you the possibility to enjoy increased profits that are much more. This is one of the biggest advantages in the pros and cons of financial leverage discussion.
3. Bigger Exposure:
You don’t have to restrict yourself from taking a single or a few lots of any call or put option just because you are short of money. With leverage, you can actually have bigger exposure in the index or stock whose option or futures contract you are planning to take.
Disadvantages of Leverage
In this section, we will explain the demerits of financial leverage, here it goes:
1. Higher Losses:
The advantage of leverage is higher profits, but what if the trade does not go in line with your expectation? The disadvantage is now you will end up losing a lot more than you would have lost, had you not opted for leverage. This is one of the main disadvantages in this analysis of the advantages and disadvantages of leverage in trading.
2. Margin Call:
A margin call can be issued in your name by the broker, and thus you will have to pledge any asset as a security deposit to cover your losses. In this case, your broker will ask you to deposit even a higher margin amount to hedge his possible losses.
3. Cost vs. Benefit:
If your position is not overnight or for the short-term, then the cost of continuing that trade can far exceed the total benefit you might get on squaring off your position. Thus, it is advisable for traders to not roll over your position for a long time and square off early, in margin trading.
This is all we had for you in this edition of the pros and cons of financial leverage in F&O trading. We hope you get a fair idea of what leverage is all about and what are the advantages and disadvantages of taking it. In a nutshell, leverage is a great tool when used judiciously with proper research and thought. Otherwise, it can wreak havoc on your trading journey. To know more about the concept of margin trading or take advantage of leverage in F&O trading, open a Demat account with us at Angel One. Our trading commission and fees are the lowest in the industry. Allow us to serve you. Happy Investing!!