From $10 to $1000

Howdy Trader!

Imagine you have $10 to invest in a lemonade stand.

Normally, with $10, you could buy a few lemons, some sugar, and maybe a couple of cups.

It's a small operation, but you can still sell some refreshing lemonade and make a little profit.

Your friend comes by one afternoon and really loves your Lemonade! In fact they believe in your lemonade-selling skills so much that they're willing to lend you a hand (or in this case, some cash).

Let's say your friend offers to lend you $90, bringing your total investment capital to $100.

This does two things for the business:

• Increased Buying Power: With $100, you can buy a lot more lemons, sugar, and cups. You could even upgrade to a bigger table or a fancy cooler to keep your lemonade icy cold.

• Potential for Bigger Profits: If the weather is hot and everyone's craving lemonade, you might sell out quickly and make a much higher profit than you could have with just your $10. In this scenario, leverage would have significantly amplified your gains.

If there are competitors in the area who are only operating on the $10 budget, you could snatch up some of their customers because your business now feels more focused and established.

Operating using the extra $90 can be likened to how leverage works. Essentially, leverage lets you control a much larger "position" in the lemonade market. The lemonade market in this case is the stock market.

Your broker can say “Hey, I believe in the Apple Stock as much as you do so here is some more cash for you to buy the stock!”.

If Apple goes to the moon, you stand to make more money than you would have made if you only bought $10 worth of stocks.

But there's a catch, just like there is with borrowing money:

• Risk of Bigger Losses: What if the weather turns out to be gloomy and nobody wants lemonade? With only $10 of your own money, you might just lose that and be out a few bucks. However, with leverage, you're still responsible for paying back the $90 you borrowed from your friend, even if you don't make any sales. In this case, leverage would have magnified your losses. The same applies to the stock, if Apple ends up collapsing, you would not only have lost your $10 but also the borrowed money. Which you still need to repay!

Your friend (broker) need to also put in some conditions in place to ensure you do not loose all their money AKA margin calls.

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Your friend (the broker) sets a rule that if the value of your lemonade stand (based on, say, the price of lemons and sugar) falls below a certain point, they need some reassurance you can still pay them back. This minimum value is called the maintenance margin.

Let's say the price of lemons unexpectedly doubles! Suddenly, your $100 worth of supplies might only be worth $60.

This means the value of your stand has dipped below the maintenance margin set by your friend. Here comes the margin call:

• Your friend calls you up (figuratively). They inform you that the value of your stand has dropped and needs to be brought back up to meet the minimum requirement.

• You have options. You can either:

  • Add more of your own money (your margin) to the stand. This is like adding more sugar and lemons to increase the value.

  • Sell some of your lemonade supplies (reduce your position). This might mean selling some cups or even your fancy cooler to get some cash back.

Leverage can be a great tool for small investors , allowing them to potentially make bigger profits.

However, it's important to remember that it also comes with the risk of bigger losses and margin calls.

Just like lemonade comes in different flavors, margin requirements can also vary depending on the asset you're trading and the broker you use. Here's how different margins are calculated:

• Percentage of the position value: This is the most common method. The broker might require a minimum margin that's a certain percentage of the total value of your leveraged position. For example, a 50% margin requirement on your $100 lemonade stand (position value) would mean you need to have at least $50 of your own money in the stand ($100 position value x 50% margin requirement = $50 minimum margin).

• Fixed amount per unit: With this method, the broker might set a fixed amount of money you need to put up for each unit of the asset you're trading. So, for example, they might require a $1 margin per cup of lemonade.

A word of caution! If you wouldn't overload your lemonade stand with ingredients you can't afford to pay back for, you shouldn't use more leverage than you're comfortable with in the stock market.