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I am a newbie and need help understanding the leverage.

Suppose I have $10k to invest and I decide to invest in 1 stock $XYZ with leverage 1:5 and that I buy 100 shares of this $XYZ at $30 per share. My investment should be $3k but because I use 1:5 leverage that would mean that I invested $600 while I "borrowed" the other $2400 right?

So if the price goes -10% ($XYZ at $24) then my position would be valued half ($300) while if the drop of the price goes -20% then I would have $0.

Did I understand this correctly or am I wrong?

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First, you're probably not going to get 5:1 leverage in the stock market. In the US, if you're holding the position overnight, you're limited to 2:1 leverage by Reg T. If you are a pattern day trader, you can get intraday leverage of 4:1 but that assumes that you're closing your position at the end of every day. Other countries may will have different rules, of course, so it is possible that you're in a country that would allow you to have 5:1 leverage, but most countries for most investors are going to set the ceiling lower.

If you could get 5:1 leverage then, yes, you could buy $3,000 worth of stock by putting up just $600. If the stock declined by 10%, your position would decline by 50%. The $3,000 in stock would be worth $2,700, you'd still owe the broker the $2,400 you borrowed, leaving you with $300. If the stock declined by 20%, you'd lose your entire $600.

Of course, assuming that the decline happens vaguely orderly (i.e. we're not dealing with a flash crash where the stock price drops 20% over the course of a few milliseconds), you'd get a margin call when your margin exceeded your broker's maintenance requirement. In the case that the stock price dropped by 10%, for example, you'd have 9:1 margin which your broker almost certainly isn't going to allow. At that point, you'd be required to deposit more money or to sell some of your stock (and if you didn't act quickly enough, the broker would sell some of your stock at whatever the current market price is).

In your actual example, though, you'd use the $10k in your account to buy the $3k in stock. You wouldn't get leverage until you purchased more than $10k in assets. The broker is going to consider all the cash in the account when determining how much you're allowed to borrow, whether you are meeting your ongoing margin requirements, etc.

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    Hi, thank you for your answer. Very informative. I do not live in the US. The broker I invest is in Cyprus and they allow 5:1 leverage. One question: I didn't fully understand this " In the case that the stock price dropped by 10%, for example, you'd have 10:1 margin". Why 10:1 margin?
    – Andrea D_
    Apr 29, 2021 at 6:52
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    @AndreaD_ - Sorry, math error, that should have been 9:1. If the stock dropped 10%, it would be worth $2,700. Your position would be worth $300 so you'd have 9:1 leverage at that point. Your broker most likely doesn't allow that so you'd most likely face a margin call at some point between when the stock started falling and the point that it had dropped 10%. If you didn't add more money to the account quickly enough, the broker would force sell the stock to ensure it got repaid. Apr 29, 2021 at 7:01
  • Excellent answer! Apr 29, 2021 at 11:55
  • Why are we assuming that the leverage is achieved via borrowing on margin, rather than by options, futures etc.? Apr 29, 2021 at 22:31
  • Portfolio margin allows significantly higher leverage than Reg T, close to 5:1 for stuff like broad-based index ETFs
    – obscurans
    Apr 30, 2021 at 7:15

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