Using Margin is Risky, Especially in a Volatile Market with Rising Inflation. Is There A Better Way?


It's easy to give in to the temptation of using margin loans to create leverage in your brokerage account. But if you do so, beware of the consequences. To start, the cost to borrow money in most brokerage accounts is between 6.00 - 9.00%. It can seem tempting to investors with a high risk tolerance to create this leverage, especially when you feel like you've found a winning stock and you want more exposure to the upside.


But besides the cost of the loan, there is another significant risk you are exposing yourself to by using margin loans, which is (Market Risk). MARKET RISK is the possibility of losses occurring due to a downturn in the overall market. This risk is magnified when you create leverage through the use of margin, because you need to keep your account within the maintenance margin requirements, which could be as high as 40%. If the minimum maintenance margin is 40%, this means you would need to have 40% of the total value of the securities on hand. As the market goes down, you may need to bring in more cash or marginable securities to meet your maintenance margin requirements. https://www.investopedia.com/terms/m/maintenancemargin.asp#:~:text=Although%20FINRA%20requires%20a%2025,total%20value%20should%20be%20available.&text=So%20if%20an%20investor%20has,%242%2C500%20in%20the%20margin%20account.


In a volatile market with rising inflation, using margin is a risky proposition. If the overall market goes down significantly, you could get squeezed out of your investments due to a margin call. You have to ask yourself... Is it worth it to create this leverage, when by doing so it could also cost me my underlying stock?


Another question you should ask yourself is... Is there a better way to create leverage in my brokerage account without borrowing and potentially creating a margin call? The short answer is yes.


CALL OPTIONS are a way to create leverage without the risk of a margin call. You also do not have to pay interest, because you are not borrowing money. Instead of borrowing money, you are purchasing the right to buy the underlying stock of a company at a specific price called the (STRIKE PRICE). When buying call options contracts, you are paying a premium for a contract. The contract represents the right to purchase 100 shares of the underlying stock at a particular price (Strike Price). The premium cost for the options contract is much less expensive than actually buying the shares of the stock. This is how you create leverage without using margin.

https://www.investopedia.com/terms/s/strikeprice.asp#:~:text=Strike%20Price%20FAQs-,What%20Is%20a%20Strike%20Price%3F,the%20security%20can%20be%20sold.


Not all call options are equal though. You should be very careful if and when you get into options trading. Some call options are much riskier than others. The amount of risk depends on the (TIME VALUE) remaining for the option and the strike price. You need to understand what you are doing before taking action.

https://www.forbes.com/2006/10/18/markets-options_education_center_advanced_value.html?sh=2da026fa3a16


Personally, I only use LEAPS (long-term equity anticipation securities), which is a type of call option that has several months or even up to three years remaining until expiration. The reason I like LEAPS is because while I may be able to identify a company that is fundamentally sound and has growing revenues, I do not have a crystal ball. Therefore, in the short-term, I cannot say with any level of confidence when a stock will go up. However, I can research a company and decide whether or not I think a stock might reach a certain price by the expiration date of the calls I'm buying. In short, the longer the time horizon, the less risk. I usually purchase call options with two years left until expiration. Since a call options contract will expire worthless if the underlying stock price is not at or above the strike price upon expiration,


The beauty of call options is that you do not have to exercise your right to buy the underlying stock. The option is a derivative with its own bid/ask price. You can decide anytime before expiration to sell it by closing it out. The key is that if you purchase LEAPS, you give yourself the opportunity to ride out the volatility in the market without the risk of owning the shares, which ties up more of your assets, and especially without the risk of owning stocks on margin, which can expose you to margin calls and the dreaded (margin squeeze).


Options are not for everyone. As a registered investment adviser, Carrano Financial Planning, LLC only makes recommendations based on a client's risk tolerance, time horizon, and investment experience.


This article is not a solicitation, and is for informational purposes only. Carrano Financial Planning, LLC does not make any guarantee of future returns.




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