Penny stocks, options and margin trading

In the best case, investing in low-priced stocks can be an exciting and profitable endeavor. In most cases, a good strategy is to maximize the leverage of invested capital by buying as many stocks as possible. When multiplied by a large position, it only takes a few pennies to make a considerable gain in a relatively short period of time.

As investors become more sophisticated, they turn to products such as options as a way to increase leverage in their positions. Given the temptation of low-priced stocks and options, it is natural for investors to try to combine the two. Unfortunately, in the case of penny stocks, trading related options is not possible.

Key points

  • Penny stocks are the company’s low-priced stocks, usually with a greater degree of risk and volatility.
  • Because of their low stock prices, investors and traders can obtain considerable positions, especially when leverage or option contracts are used.
  • However, leverage can amplify the risks and volatility associated with low-priced stocks, so be careful!

Low-priced stocks, options and margin trading

Small-cap ETF options

Although it may not be possible to trade options on specific penny stocks, you can still use options to take advantage of the potential of small-cap or micro-cap stocks. A popular product for trading small-cap stocks is the iShares Russell 2000 ETF (IWM). For those who are not familiar with the product, IWM aims to track the investment results of an index composed of US small-cap stocks.

Let’s look at a historical example: In the twelve months ended September 23, 2014, the IWM rate of return was 17.62%. Although you cannot trade options in many components, you can trade options on the ETF itself. Small changes in the underlying ETF usually translate into major changes in options. Compared with the stock itself, one of the biggest benefits of small-cap ETF trading options is that it eliminates most company-specific risks.

Margin Account

Another way to increase leverage on low-priced stocks is to set up a margin account. This type of investment account allows investors to use the existing capital and securities in the account to obtain additional capital. In essence, this is equivalent to borrowing money from your broker, using existing cash and securities as collateral, and then paying interest on the borrowed money to obtain the right to use the funds to buy and sell stocks.

Although margin trading provides investors with additional leverage, it is extremely risky. Many people don’t approve of using money you don’t have to buy any type of stock. If used incorrectly, it may lead to financial collapse. A good rule is that whenever you use margin or any form of leverage to buy financial assets, you should proceed with caution.

Bottom line

Buying penny stocks with cash can be a risky approach. In other words, some traders hope to increase their leverage on low-priced stocks by using products such as options. Unfortunately, in most cases, options cannot be used to trade penny stocks. However, some traders with risk tolerance can use ETF options as a workaround. Some traders may even take advantage of their margin accounts when trading low-priced stocks, but this should be considered as a last resort and should be used with extreme caution.

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