Over long periods of time, the stock market has compounded at an annualized rate of somewhere between 9% and 10%, including dividend reinvestment. That's a fast enough rate to turn ordinary people into millionaires if they invest consistently enough throughout their careers. Of course, few people start investing early enough in their careers to make that path easy. Others want a faster way there or to reach a wealth target beyond that million-dollar threshold.
For them, options, margin, and other risky investment practices offer up the potential for faster returns, albeit with lots of strings and risks attached. Those risks could cause you to lose even more than you invested in total. As a result, they're tools that should only be used if you fully understand the risks and limit your exposure to where they won't run your future if and when things move against you. Read on for some of the basics that you'll be facing if you choose to use them.
What is investing on margin?
When you invest on margin, you're essentially borrowing money from your broker to buy securities. That leverages your potential returns, both for the good and the bad.
For example, assume you have $1,000 in cash and want to buy $2,000 worth of a stock that trades at $10 a share. You can put up $1,000 of your own money, borrow $1,000 from your broker, buy 200 shares, and you'd own $2,000 worth of that stock. Your net account balance would still look like you have $1,000, but it would show up as $2,000 in stock and a $1,000 margin loan from your broker.
If the stock went up from $10 to $12, that's a 20% increase. At that point, your 200 shares would be worth $2,400, and your account balance would reflect a total value of $1,400 ($2,400 in stock, minus the $1,000 margin loan). That's a 40% increase to your account value on only a 20% increase in the stock price.
Of course, margin cuts both ways. Say that stock instead dropped 20% from $10 to $8. At that point, your 200 shares would be worth $1,600, and your account balance would reflect a total value of $600 ($1,600 in stock, minus the $1,000 margin loan). That's a 40% decrease to your account value on only a 20% decrease in the stock price.
In addition to magnifying the swings in value, investing on margin brings with it other risks. First and foremost, you will pay your broker interest on any money you're borrowing when you invest with margin. At Fidelity, for instance, the recent cost to borrow money on margin on balances up to $24,999 was 8.325%. When you compare that rate to the 9% to 10% potential annual return in stocks, you'll quickly recognize that you're taking the risk, but the broker is getting much of the rewards.
In addition, while you have a margin loan outstanding, your broker may issue something known as a margin call -- particularly if the market moves against you. When you have a margin call, you broker can demand you pony up more cash or sell out positions you currently own in order to satisfy the call. If you can't cover the call, your broker will liquidate your positions to get it covered.
If your broker starts selling out your positions, that broker doesn't care about your tax situation, your view of the company's long-term prospects, or anything else other than satisfying the call. If the market really moves against you -- say that stock you bought on margin declared bankruptcy and became worth $0 -- you're also still on the hook for the money you borrowed.
What about options?
Options are what is known as a derivative security -- which means they derive their value from some other investment (such as a stock). Options come in two flavors, calls and puts. Buying a call gives you the right to buy the underlying investment at a certain price on or before a certain date. Buying a put gives you the right to sell the underlying investment at a certain price on or before a certain date.
Most publicly traded options contracts on stocks cover 100 shares at a time, and the buyers and sellers of those options often create the contracts when they initiate their opening transactions. Because options expire, part of their value comes from the amount of life they have left (time value). The other part of their value (intrinsic value) comes from how far above the contract price the shares are trading if it's a call option or how far below the contract price the shares are trading if it's a put option.
Because of that contract price -- known as the strike price -- options are also leveraged investments that can move far more than the underlying stock. That provides the potential for magnified returns to both the upside and the downside. It's important to understand, too, that thanks to the time value involved along with the options limited lifespan, options sellers get paid up front and thus are willing to take the risk that the market moves against them.
Here's an example of how options work. Imagine there's a stock trading at $50 per share, and that stock has call options available for three months from now. If the $50 call option trades for $2, you can buy one contract for $200 ($2 per share, 100 shares per contract). If three months from now, just before expiration, the stock trades at $55 per share, your options would be worth $5 per share, or $500 total.
You can then sell that option, and you would have more than doubled your money in the space of three months. That's an amazing return, particularly when you compare it to the 10% move in the underlying stock. Also note that the options seller -- your counterparty to that trade -- would be out a net $300 ($500 at expiration, less the $200 premium received when setting up the option). In this way, it's possible to lose more than 100% of your investment when trading options.
Of course, that potential return is exceptionally risky. If the stock closes at or below $50 when the option is about to expire, the option is worthless, and you will have lost 100% of your investment. That's despite the fact that you would likely have still had something had you owned the stock, Likewise, if the stock closes between $50 and $51.99 just before expiration, you would wind up losing money on the option. That's despite the fact that you would have made a little money if you owned the stock.
Throwing more fuel on the fire
As if the leverage natively embedded in options weren't enough, you can combine the two and use margin to buy and sell options. With that combination, you magnify the potential returns as well as the very real risks you're taking on with your strategies. Unfortunately, that combination brings even risks above and beyond the mere leverage involved.
Remember that options expire and brokers can initiate a margin call if your balance gets too low relative to the amount you've borrowed. That combination means that if the market moves against you in the short term, you can lose everything -- potentially even more than you invested -- because of bad timing, even if the strategy would have ultimately worked out for you in the long run. That risk is real, and it can burn you.
There's no such thing as a free lunch
Beyond options, margin, and the combination of the two, there are also other high risk, high potential reward strategies, such as speculating in the futures market. Similarly, those alternative investments also carry with them leveraged potential returns, along with the possibility of losing more than you invested when the market moves against you.
All these strategies and tools look tempting on the surface because they offer that potential of faster returns if things go well. In reality, reaching for those potential rewards require you to take on substantial real risks above and beyond the typical risks of ordinary stock investing.
As a result, they should only be considered by very experienced investors who fully recognize those risks. Even then, those investors who want to use them should carefully limit their total exposure so that when the market moves against them, it doesn't jeopardize the rest of their financial position.