Leverage using Calls, Not Margin Calls

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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. A most common way to do that is to buy stocks on margin.

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 – up to 2 years with LEAPS® options. 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

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Leverage using Calls, Not Margin Calls

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Leverage and Margin Calls

What is Leverage?

In forex trading, leverage is an added capacity given to a trader by the broker to control larger positions than the trader’s equity can ordinarily handle. Since money is what is used to buy and sell currencies, such added capacity comes in the form of an enhanced financial capability. So leveraged trading is actually trading on borrowed funds in order to control larger positions and have the opportunity to make enhanced profit.

The Concept of Leverage

Why is it necessary to trade with leverage in forex? In forex, the currency movements are measured in percentage interest points (PIP), which are in four or five decimal places. So one percentage interest point or PIP, is the equivalent of 0.0001 points. Obviously such price movements are too small to command any real financial value, so trades must have to be in very large volumes to be able to command sizeable gains.

A standard lot, which pays $10 a pip, is the equivalent of 100,000 units of the account currency (100,000 units X 0.0001 = 10). How many traders can afford to cough out $100,000 or 100,000 Euros for a single forex trade? Not many. That is why brokers have stepped in to provide leverage, so as to allow traders to control such volumes even when they do not have such amounts in their accounts.

The way leverage works is this. There are certain ratios provided which pit the trader’s capital against the broker’s provided extra, and this forms the leverage applied to the account. Leverage ratios can therefore range from 50:1 all the way up to 500:1, in which the larger figure is the broker’s provided capital for the trade, and the smaller figure is the trader’s capital. Usually the trader is expected to bring some capital so as to collateralize the broker’s capital. If the trade goes as planned, the trader reaps the full profit. If the trade goes against the trader, the loss is taken from the trader’s portion. However such losses are usually taken from the trader’s portion of the capital invested in the trade, known as the used margin.

The Margin Call

The rest of the capital not used in the trade is usually left untouched, as long as the used margin can cover for any losses incurred. However, when the margin used as collateral for the trade is used up by increasing amounts of loss in active trades, such losses will now spill over into the unused margin. It is only when the losses now get to a degree large enough to obliterate even the unused margin in the trader’s account that a margin call is now issued.

A margin call is an instruction from the broker to the trader to add more funds to his trading account in order to maintain the required margin for the trade or risk getting all open positions closed out in order to preserve the broker’s capital used for leveraging the trade.

Leverage and Margin Calls: The Relationship

So now that we know about leverage and margin calls, what is the relationship between both?

There are two types of leverage:

a) True Leverage: This is the full amount that a trade position is worth divided by the amount you have in your account.

b) Maximum Leverage: When you see leverage of 400:1 being advertised on broker platforms, this is the maximum leverage that the trader can use. It does not make this a good leverage to use. Indeed the use of such high leverages is dangerous as we shall show you now.

Chris has a $50,000 trading account and buys 2 standard lots of USDCAD at parity price of $1.0000. The full value of his position is $200,000. From our definition of true leverage above, his true leverage is 20:1 ($200,000 / $10,000).

Chris decides to put on three more standard lots of USDCAD based on some analysis which he thinks will favour his position, again at the same price. The full amount of his position is now $500,000. Chris now is using a true leverage of 10:1 ($500,000 / $50,000)

Chris’s broker has a margin requirement of 1%, meaning that at all times, Chris must have at least 1% unused margin in his account. Chris has an account balance and equity of $50,000, but he has used a Margin of $5,000, with a Usable Margin of $5,000.

Balance Equity Used Margin Usable Margin
50,000 USD 50,000 USD 5,000 USD 45,000 USD

With a pip value of $10 per pip (1 lot = 100,000 value and 100,000 X 0.0001 points = $10), margin call can only be issued when the position is negative by 900 pips ($45,000 Usable Margin divided by $50/pip, since Chris has assumed a position of 5 lots).

Assuming Chris had $500 in his account instead of $50,000 (as most retail traders do), and he bought 2.5 Mini lots of USDCAD at 1.0000. The full amount of this position is $25,000 and account balance is $500, which gives a true leverage of 50:1.

Balance Equity Used Margin Usable Margin
500 USD 500 USD 250 USD 250 USD

Here, all that needs to happen for a margin call to be issued is for price to move 100 pips ($250 Usable Margin divided by $2.50/pip).

It is not hard to see the effects of true leverage and how excessively high leverage combined with underfunded accounts can easily lead to a margin call.

Traders with underfunded accounts tend to use excessive leverage in order to compensate for the reduced amount of weight they can pull in the market when assuming positions. It will not take much of a loss in a trade for the used margin in such trades to get wiped out, and for the unused margin to start taking hits.

Excessive leverage also has another major drawback: they tempt traders into opening more positions than they need to. Over trading is a major cause of margin calls, as it is usually difficult for traders to maintain control over several positions open at the same time.

More About Adam

Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

Leverage using Calls, Not Margin Calls

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