Last Updated on November 21, 2022 by Oddmund Groette
The strategy of using other people’s money to trade is by no means recent. In fact, leverage is popularly used in stock and forex trading, particularly in a bullish market. Leverage can come in various forms, such as taking out direct loans or borrowing from the broker. Regardless of its form, the appeal of using leverage to trade is simple – it amplifies profits.
However, this is not the only side of the story. As much as leverage can amplify profits, it also has the potential to amplify your losses, thereby putting you in a precarious situation. This is why Warren Buffett stated that borrowed money has gotten some people very rich and some very poor.
Clearly, using borrowed money is a contentious issue, with some absolutely for it and others against it.
Should you use credit to trade? What to Consider
The decision to use borrowed money for trading comes down to comparing the expected returns of the investment and the cost of borrowing. In essence, if the returns exceed the cost, one might assume that using borrowed money in that scenario is acceptable. The problem, however, is that even this formula is not perfect.
Borrowing costs are typically fixed, while return on investments can be volatile and unpredictable, depending on the investment. As such, an investment with a high expected return might yield a much smaller return or even a loss, leaving the trader in debt. Thus, the risk of the proposed investment is an important factor to consider when deciding whether to use borrowed funds.
To an extent, the risk of investment can be limited through diversification. Hence, if a collection of investments offers a much higher rate of return relative to the cost of borrowing, the transaction might be worth considering.
Other factors to consider include age. Younger people are believed to have a higher capacity for risk. Since borrowing money to trade is a risky venture, it might be more suited to young people as opposed to persons closer to retirement.
In addition, the general interest rates at the time of investment are also an important factor you may want to consider. For instance, a period of low-interest rates is ideal for investing with borrowed funds. Similarly, if you have a high credit score, you may have access to credit facilities with much lower interest rates, therefore, placing you in a better position to make such a transaction.
How to borrow to invest
Here are a couple of ways you can use leverage to trade:
Buy on margin
One way to borrow to trade stocks is by buying on margin. This simply means borrowing money from your broker to buy a stock and making your investment your collateral. This strategy can allow you to own more stock without paying entirely with cash.
Buying on margin can be really profitable if the stock appreciates considerably in the short term. This way, you can take the total capital gains while paying the broker back with interest. However, buying on margin can also result in massive losses.
Take out a loan
You can also explore taking out a loan to invest. This could be a personal loan, provided the lender places no restrictions on what you can use the loan for. Similarly, you can use a home equity loan. You can explore options like online payday loans and quick loans. Ensure you pay attention to your interest rate when taking a loan to trade. You can leverage a free personal loan calculator to understand your borrowing costs accurately.
Regardless of your view on the matter, it is clear that borrowing money to trade is risky. Even if you decide to make such a transaction, it is important to be cautious. Thus, pay attention to the terms of your credit and assess the risks thoroughly.