Margin and options trading are two investment strategies that investors may utilize when investing in the financial markets. Investors who use margin and options trading rely on leverage to potentially accelerate their gains while also risking big losses if their trades do not work out.
While margin and options trading have several similarities, there are also subtle differences between the two investing strategies. Savvy investors will want to know how both margin and options work to know when to choose the best strategy for their unique situation.
Options Trading vs Margin Trading
Here are some similarities between margin trading and options trading:
• Both options trading and margin trading allow you to leverage your investment dollars.
• Higher potential rewards but also higher risk.
• Requires additional account approvals from your broker.
Here is a look at the differences between options trading and margin trading:
• Margin trading involves a loan from your broker. You can get involved with options trading without borrowing.
• Using margin directly increases your buying power, while options trading allows you to control shares of stock with less money.
Options Trading and How It Works
Options are financial derivatives that allow an investor to control a particular security, like a stock or exchange-traded fund (ETF), without needing all the money to buy or sell the asset directly. The purchaser of an options contract has the right to buy or sell a security at a fixed price within a specific period of time, paying a premium for that right.
There are two main types of options contracts: call options and put options. A call option gives the purchaser the right – but not always the obligation – to buy a security at a specific price, called a strike price. In contrast, the purchaser of a put option has the right – but again, not always the obligation – to sell a security at the strike price.
Buying and selling call and put options are some of the various ways investors can use leverage to accelerate their gains. And since options contracts fluctuate in value, traders can buy or sell the contracts before expiration for a profit or loss, just like they would trade a stock or bond. This process of buying and selling options contracts is known as options trading.
💡 Recommended: Options Trading 101: An Introduction to Stock Options
How Does Options Trading Work?
Suppose stock ABC is trading at $40 per share. If you buy the stock directly like a traditional investment and the stock price goes to $44, you will have made a 10% profit.
However, you could also buy a call option for stock ABC and potentially accelerate your gains.
Say that a call option with a strike price of $40 for stock ABC is selling for a $1 premium. When the stock price moves from $40 to $44, the call option premium might move to $2. You could then sell the call option, pocketing the difference between the price of the option when you sold it and what you paid for the option ($2 – $1). That would represent a 100% return on your investment, not including commissions and fees.
Calculating the pricing of options can be complicated, but this simple example shows one way investors can use options trading to leverage their investments.
There are many ways to trade options, depending on your outlook on a particular asset or the market as a whole. Investors can utilize bullish and bearish options trading strategies that target short- and long-term stock movements, allowing them to make money in up, down, and sideways markets.
Aside from speculating on the price movement of securities, investors can use options to hedge against losses or generate income by selling options for premium.
💡 Recommended: How to Trade Options: An In-Depth Guide for Beginners
Pros and Cons of Options Trading
Here are some of the pros and cons of options trading:
|Pros of Options Trading||Cons of Options Trading|
|Allows you to use leverage for potentially increased returns||Options generally have less liquidity than stocks|
|You can use options trading to speculate on the price movement of stocks, hedge against risk, or generate income||Depending on your options strategy, you may have unlimited risk|
|Options trading may require a smaller upfront financial commitment than investing in stocks directly||You need to be approved by your broker to trade options|
Margin Trading and How It Works
Margin trading is an investment strategy in which you buy stocks or other securities using money borrowed from your broker to increase your buying power. You can potentially enhance your returns by using margin loans to purchase assets. However, using margin to buy securities can also magnify your losses.
In contrast, when you buy a stock directly, you pay for it with money from your cash account. Then, when you sell your shares, your profit (or loss) is based on the stock’s current price. This traditional way of investing limits gains, at least compared to margin trading, but also curbs potential risk: you can only lose as much as you invest.
Like options trading, margin trading is another way to increase your leverage in a particular investment. If you want to start trading on margin, you’ll likely need to upgrade the type of account you have with your broker. There are some subtle differences between a cash and margin account, and you’ll want to ensure you have the proper account to trade on margin.
How Does Margin Trading Work?
After your broker approves you for a margin account, you can buy more stocks than you have cash available.
Here’s one example of how margin trading works: suppose that you have $5,000 in your account, and you want to buy shares of stock ABC, which is trading at $50 per share. With a regular cash account, you would only be able to buy 100 shares, since $50 multiplied by 100 equals $5,000. If the stock’s price goes up to $55, you can close your position with a 10% profit.
But if you have a margin account, you can buy additional shares. Your broker will approve you for a certain amount of margin. If your broker has approved you for a $5,000 margin loan, you now have $10,000 in buying power; you can buy 200 shares of stock ABC at $50 per share. If the stock’s price goes up to $55 in this example, your profits will be higher. You can sell your 200 shares for $11,000. Then, after repaying your margin loan, you still have $6,000 in your account, representing a 20% profit.
Keep in mind that the increased leverage works in both directions. If you buy a stock on margin and the stock’s price goes down, you will have higher losses than you would if you just purchased with your cash account.
If you enter into a margin position and the value of your account drops, your broker may issue a margin call and force you to either sell some of your holdings or put in additional cash. Your broker will require both an initial margin amount and a maintenance margin amount.
Pros and Cons of Margin Trading
Here are some of the pros and cons of margin trading:
|Pros of Margin Trading||Cons of Margin Trading|
|Increased leverage and buying power on your investments||Higher risk if your trades move against you|
|Buying on margin may enhance your investment choices||Your broker may force you to add more cash and/or sell your investments if they issue a margin call|
|Margin loans are often more flexible than other types of loans||Most brokers charge interest on the amount they loan you on margin|
How to Decide Which Is Right for You
Both options and margin trading can be successful investment strategies under the right conditions.
You may consider margin trading if you want to enhance your buying power with additional capital. If you want a type of investment with more flexibility, options trading might be suitable for you.
In either case, make sure you manage your risk so that you aren’t put in a situation where you lose more money than you have available.
Investing with SoFi
Options and margin trading are just two of the many investing strategies you can use to grow your wealth. But you don’t have to utilize these risky trading strategies to build your portfolio. With a SoFi Invest® online brokerage account, you can trade stocks and ETFs with no commissions for as little as $5.
And if you’re up for the risk, SoFi offers margin trading that can increase your buying power. But before you get started, your account must have a balance of at least $2,000 and be approved for margin trading. Once approved, you can borrow money against your current investments to buy stocks and ETFs at a competitive interest rate and potentially increase your returns.
Is margin trading better than options trading?
Neither margin trading nor options trading is necessarily better than the other. Both options trading and margin trading can make sense in specific situations. Which of these two investment options is best for you depends on your specific financial situation and goals.
How much margin is required to buy options?
Margin is not required to buy or sell options contracts. However, you may use a margin loan for options trading if it’s appropriate for your investing strategy.
Are options trading and margin trading the same thing?
While both options and margin trading allows you to use leverage to potentially increase your returns, they are not the same. Options trading involves trading options contracts, while margin trading involves borrowing money from your broker to make investments with more cash than you have in your account.
Photo credit: iStock/Just_Super
*Borrow at 5.25%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.