There are several ways to increase the power of money. Using margin, that is, borrowing money from a stockbroker or investing in options can enable the investor to double his money or more, at risk of great losses.
Margin Borrowing
After placing an initial investment into a brokerage account, some brokers may allow funds to be borrowed using the money or stock investments in the account as collateral.
Not all stocks can be bought using margin, and cannot be used as collateral. Generally, stocks under a certain dollar amount or stocks with high volatility are not eligible.
If a stock is eligible to be bought on margin, this can effectively double the amount of stock that can be purchased. For an example, assume stock XYZ is marginable at 100%, and the price is $50 a share.
If the account has $5,000, then the holder can purchase 100 shares of XYZ stock, and then use that stock to purchase another investment. If he chooses to buy another 100 shares, and the stock price goes to $60, he can sell all 200 shares for a profit of $2,000, less fees and interest.
Negatives of Margin Borrowing
In the example, if the price drops to $40, the investor can only sell the 200 shares for $8,000. He then must repay the $5,000 to the broker, plus interest, leaving his account at less than $3,000.
If the value of the account drops below a predetermined percentage, the broker will require that the investment be sold or additional monies be added to the account.
This “margin call” can place the investor in a position of selling an investment at an inopportune time. It is therefore very important to maintain sufficient margin in the account for declines in the stock.
Using Options for Leverage
Options allow for an investor to control a large amount of stock by only paying for the option to buy a number of shares at a certain price for a specified time.
As an example, the XYZ stock above may have an option to buy 100 shares at $60, good for one month, costing $2 per share, or $200. By paying $200, the option becomes “in the money at $60. If the price goes to $65, the investor will have an option work $500, for only a $200 investment.
Loss of the Entire Investment
If the option is held it expires, and the stock does not reach $60, the option is worthless, and the entire $200 is lost.
When to Use Leverage
Great care is needed when using leverage, or borrowed money. No investment is guaranteed to increase in value and certainly not within the time frame required for borrowing or options expiration.
By establishing parameters and knowing their risk tolerance, an investor can use leverage to increase their investments. Knowing the negatives can help an investor make intelligent speculative decisions.
