Be Aware of Over-Leveraging in the Stock Market

Leverage is a double-edged knife in the stock market. While leverage gives investors a full bang for their buck, it also caught them unfit for this explosive risk exposure. In India, people should be aware of over-leveraging in the Stock Market because it creates lots of bad effects for both retail investors and companies alike. 

This blog shall discuss over-leveraging, and the risks involved so that you can be aware of over-leveraging in the Stock Market.

Why We Should Be Aware Of Over-Leveraging In The Stock Market

Leverage is investing in borrowed funds in the stock market to multiply one's returns. Simply put, this lets you trade money more than what you own. For instance, if one has ?1 lakh and leverages at 1:4, this means one can trade using ?4 lakhs. While this takes the profit into multi-fold growth, it also damages the losses into an equivalent rise.

The Lure of Over-Leveraging

Investors view leverage to be enticing, particularly beginning investors, because it gives them the false impression that profits can be made quickly and easily. Such a lucrative offer from brokers on margin minimums so low sees some investors indulging themselves in high-leverage trades without very good knowledge of their risks.

Pretty tempting, isn't it? Well, yes and no: Remember that leverage multiplies everything—good or bad—by a relatively higher number, making one's mistakes appear gargantuan.

Risks Associated with Over-Leveraging

1. Magnified Losses

The risk of over-leveraging can be overstated. For example, if investing ?1 lakh with 4x leverage (?4 lakhs total), and the market drops by 10%, it means that you lose more than ?10,000. This loss increases to ?40,000 which is almost 40% of the capital you invested

2. Margin Calls

With higher leverage comes greater minimum requirements for margin, ultimately set for a trader with the broker. In the event that his capital falls below minimum margin requirements, then a margin call may be issued, calling for the trader to inject more cash. If the margin call is still not responded to by payment of cash or privileges, forced liquidation may ensue on the part of traders, forcing some positions to be closed without their combination of margin finishes, leaving them in deep trouble.

3. Psychological Pressure

Over-leveraging can take a toll on your mental health. Watching your losses pile up due to leverage can lead to anxiety, fear, and rash decision-making. This psychological strain often results in impulsive trades, worsening your financial situation.

4. Market Volatility

The Indian stock market is full of volatility no doubt. Leverage can turn even small price fluctuations into significant financial swings. For instance, during events like the Union Budget announcement or major global market movements, leveraged positions can be highly unpredictable and risky.

5. Potential Bankruptcy

For extreme cases of over-leveraging, losses can surpass the initial capital invested. In such scenarios, investors may find themselves in debt, as they have a requirement to repay borrowed amounts even if their investments perform poorly. This has led many to financial ruin.

Real-Life Example

In 2020, many Indian retail investors, who were highly leveraged, faced big losses during the market downslide triggered by COVID-19. A stock like Yes Bank and Jet Airways had higher volatility. For example, if an investor had taken a leveraged long position in Yes Bank shares while the free fall was happening, there would have been margin calls and forced sales (liquidation) subsequently losing out on their entire savings in a matter of days.

How to Avoid Over-Leveraging

1. Understand your Risk Profile

• Evaluate your financial condition and that is the reason we should be aware of over-leveraging in the stock market for risk appetite for using leverage.
• Only invest money that can be lost, and ensure that essential savings are kept at bay.

2. Limit Your Leverage Ratio

• Stick to conservative leverage ratios.
• A ratio of 1:2 or lower is generally considered safer.
• Avoid chasing higher ratios that promise bigger profits but come with greater risks.

3. Set Stop-Loss Orders

• Stop-loss orders would limit your risk exposure by automatically executing a trade if the price falls to a certain level.
• This can help prevent losses from spiraling out of control.

4. Diversification of Your Portfolio

• Diversification minimizes losses in the case of an investment in one stock or sector.
• It serves as cushioning for your investments.

5. Educate Yourself

• Take your time to learn about stock markets and leverage. By getting proper pieces of information then only you can be aware of over-leveraging in the stock market.
• Understand the workings of margin trading, interest costs, and how market volatility affects leveraged positions.

6. Avoid Emotional Decisions

• The most common fault we find in any investor in the stock market is their greed and fear after investing.
• A trader must have a well-developed trading plan and never make hasty decisions, especially under duress.

Conclusion

Leverage has always been a double-edged sword in the stock markets, and over-leverage has always led to severe devastation and ruin in stature overall. It is all the more scary for Indian investors to understand how to gauge these risks and manage bullishness. Stick with conservative strategies, nurture realistic expectations, and learn incessantly how to stay afloat and be aware of over-leveraging in the Stock Market, always remember it is better to generate wealth gradually rather than zone on the lesser journey of quickly losing it.

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