Derivatives and advanced market conceptsModule 2, lesson 8 of 21
Leverage and margin
Exposure against capital, leverage ratios and margin trading, and the arithmetic of how leverage turns ordinary price moves into large losses.
In this lesson
- Calculate exposure, capital and the leverage ratio of a position.
- Calculate the effect of a price move on capital at different levels of leverage.
- Find the price move that wipes out the capital at a given leverage.
- Explain how margin trading facilities and derivatives create leverage, and why losses can exceed capital.
Builds on
- What derivatives areDerivatives are the most common source of leverage for individuals.
- Percentages, percentage change and percentage pointsThe calculations here are percentage changes on exposure and capital.
On this page
In simple terms
Leverage means controlling a position larger than the money you put in. If you put up ₹1 lakh and control ₹5 lakh of shares or contracts, your exposure is ₹5 lakh and your leverage is five times.
Leverage does not change how much the price moves. It changes how much of your money each move represents.
Measuring leverage
| Exposure: the full value of the position | ₹5,00,000 |
|---|---|
| Capital: your own money at risk | ₹1,00,000 |
| Leverage: exposure ÷ capital | 5 times |
The arithmetic of leverage
The effect of a price move on your capital is roughly the move multiplied by the leverage.
Worked example: ₹1 lakh of capital at different levels of leverage
| Price move | No leverage | 2 times | 5 times | 10 times |
|---|---|---|---|---|
| +10% | +10% | +20% | +50% | +100% |
| −5% | −5% | −10% | −25% | −50% |
| −10% | −10% | −20% | −50% | −100% |
| −20% | −20% | −40% | −100% | −200% |
At ten times leverage, a 10% fall wipes out the capital, and a 20% fall loses twice the capital: the trader owes the broker another ₹1 lakh.
A useful rule:
Fall that wipes out capital ≈ 100% ÷ leverage
At 5 times, about 20%. At 10 times, about 10%. At 20 times, about 5%.
Shares and indices regularly move by these amounts. The leverage calculator works this out for any position.
Where leverage comes from
- Futures: margin is a fraction of contract value, as the futures margin lesson explains.
- Options: a small premium controls a large position, as the strikes and premiums lesson shows.
- Margin trading facilities: brokers lend part of the money to buy shares, charging interest. The rules on which shares qualify and how much can be borrowed are set by SEBI and the exchanges and change over time.
- Personal borrowing used to invest, as the investment mistakes lesson discusses.
What comes with leverage
- Margin calls: when losses reduce your capital below the required level, you must add money at short notice or be closed out, as the margin call entry explains.
- Forced selling at bad prices: positions are often closed during sharp falls, locking in losses before any recovery.
- Interest costs on borrowed money, which reduce returns every day the position is held.
- The maths of recovery: a 50% loss of capital needs a 100% gain to recover, as the volatility lesson explains.
Why leverage tends to hurt individuals
Leverage magnifies whatever edge a trader has, and also whatever disadvantage. Most individual traders face costs, slippage and better-informed competitors, so their average result before leverage is slightly negative; leverage magnifies that into larger losses. Combined with the emotional pressure of fast losses, as the emotional decisions lesson explains, it is a leading cause of large individual losses in markets.
Why it matters
Leverage is built into every derivative. Calculating exposure, leverage and the move that wipes out your capital before taking any position is the most basic safeguard, and it often shows that a position is far larger than it felt.
Limitations
The examples ignore costs, interest and taxes, which make every leveraged loss worse. Real margin requirements vary with volatility and broker policy, and change over time.
Common mistakes
- Measuring risk by capital put in rather than exposure.
- Thinking leverage only affects gains.
- Keeping no reserve for margin calls.
- Using leverage to recover losses, which usually deepens them.
Try it yourself
- For a position with ₹50,000 of capital and ₹4 lakh of exposure, calculate the leverage.
- Calculate the effect on capital of moves of +5%, −5%, −12.5% and −20%.
- Use the leverage calculator to find the fall that would wipe out the capital, and compare it with how much the underlying has moved in its worst week in recent years.
Key takeaways
- Leverage means controlling an exposure larger than your own capital. The leverage ratio is exposure divided by capital.
- A price move's effect on capital is the move multiplied by the leverage. At five times leverage, a 10% fall costs half your capital.
- At a leverage of L, a fall of about 100 ÷ L per cent wipes out the capital. Beyond that, you owe money.
- Derivatives, margin trading facilities and borrowing all create leverage. Leverage also brings margin calls, interest and forced selling at bad prices.
- Leverage multiplies losses as surely as gains. With costs and the maths of recovery, it tends to make outcomes worse for most individuals.
Check your understanding
Try the numbers yourself
- Leverage calculatorWhat does borrowing to invest do to my risk?
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Terms used in this lesson
- Leverage
- Using borrowed money, or products such as futures and options, to take a bigger position than your own money allows, magnifying gains and losses.
- Exposure
- The full market value of a position, which can be much larger than the money put up to hold it.
- Margin call
- A demand from a broker or lender for more money when a leveraged position falls, failing which the position can be sold.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.