Leverage using Calls, Not Margin Calls
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk.
Buying on margin lets the investor use stocks as collateral to borrow money to buy more stock. Currently, investors can borrow up to half the value of the stock they wish to purchase. Your broker gladly loans you as much money as you put up, and charges you a very attractive interest rate. If the stock goes up by $1, you gain $2 since you have now have twice the number of shares. Higher risk, higher profit.
Suppose you have $10000 and wish to buy some shares of XYZ stock currently trading at $50. That amount will only allow you to buy 200 shares. Buying on margin lets you borrow another $10000 so you can buy a total of 400 shares. The total investment is $20000.
Buying on margin, however, is like a sword that cuts both ways. While its nice to know that you are earning $2 every time the share price goes up by $1, the converse is true. Every time the stock drops by a dollar, you also lose $2. Worse yet, if the stock price comes crashing down, you get the dreaded margin call and may be forced to sell the stock at the very time when you would rather be buying it instead.
Alternatively, with call options, you pay a premium for a right to purchase the underlying stock at a predetermined price (strike price) for a period of time. In simpler terms, buying call options is like renting the underlying stock. Each call option represents 100 shares.
Following the same example above, suppose a 3 month call option on XYZ stock with strike price of $50 is available for $3 each. To control the same amount of XYZ stock, which is 400 shares, requires the purchase of 4 call options for a total investment of only $1200. This is also the maximum amount you can lose if you are wrong about the stock. Comparatively, leveraging using margin requires a hefty $20000 and worse still, you risk a margin call!
Hence, buying on margin is a dangerous way to gain leverage, especially when the underlying stock is very volatile. A better option will be to buy call options instead. In options trading, the purchase of call options is better known as a call buying or long call strategy.