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Leverage – Worth The Risk?

Are you willing to borrow money to invest? Given the volatility of today's stock market, leverage might not be as good an idea as it was in the past. But even traders who shun the idea of borrowing to invest might cheerfully invest on margin.

Of course, margin is a form of borrowing. You are going to have to repay the margin funds you borrow and if the market moves in the wrong direction, you could lose money very quickly. For example, if you put in $5,000 to buy 100 shares of a $100 stock, you start out with $5,00 in cash and $5,000 borrowed. This is great if the stock moves to $120, in which case your investment is worth $12,000 ($5,000 owed to your brokerage and $7,000 cash). But what if the price of the stock moves down to $7,000?

When the price falls, two things happen. First, your cash value falls to $2,000 and the rest, $5,000, is still owed and on the books. Second, you are going to get a margin call. Your brokerage firm maintains a 50% margin for stocks, so with an investment worth $7,000 you must have $3,500 (50%) in cash or other stocks. But with only $2,000, you must come up with another $1,500 just to meet margin requirements. Now you are in $6,500 in cash (initial $5,000 plus another $1,500) for an account worth $7,000; and you still own $5,000 on margin (the original amount you borrowed).

Margin is a form of debt and, like other forms of leverage, it is risky. Most forms of leverage are like this, too. One exception: Instead of buying 100 shares of stock, you can buy options. Each option controls 100 shares but costs a small fraction, averaging 5% or less. So you could control 100 shares of a $100 stock for $500 or so (the price varies based on time to expiration and proximity of stock price to the option's strike price). But options are complicated and you need to be sure you know what you're doing before you start buying them. Three out of four options expire worthless, so while options get around leverage risk, they pose a different kind of risk in its place. Some option strategies are very conservative and avoid these problems, but option trading demands that you know the market well before you begin trading.

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