One of the most frustrating things when you’re just starting out investing is that you never seem to have enough money to buy all the stocks you’d like to invest in.
Most good stocks cost anywhere between $50–$350, with some, like Google (NASDAQ: GOOGL) and Amazon (NASDAQ: AMZN), costing over $1,000 per share.
So if you only have a small amount to invest per month, it can feel confining. You have the choice of buying one or two good stocks, or adding to one of your current positions.
And of course, when you’re just starting out, growth can feel insanely slow. Even with the current bull market, where it grew almost 30% last year, that’s only a gain of a few hundred dollars if your portfolio is, say, $3,000 or less. Not exactly very exciting when you’re looking at it day-to-day.
I started out with a very small portfolio. I had no stashes of money set aside to deploy in the market, but just had to add a bit from each paycheck. Before I quit my job last month, I had been adding around $1,000/month to the market, but that accounted for about 25% of my monthly take-home pay, so granted most people probably aren’t investing that much.
What’s the small-time investor to do? Just add trickles of money here and there until it adds up to something sizable?
That’s what most personal finance advisors would tell you to do. And it’s not a bad idea — but again, it’s kind of boring. And I’m not known for having the most patience.
What if I said there’s a shortcut? What if I said you could leverage your portfolio of, say, $2,000, as if it were actually $200,000?
By the way, $2,000 is just an example. I’ve heard of people turning just $100 into several thousand. There’s really no limit here.
Would you think I was crazy? Or trying to scam you into buying some expensive investment product promising ridiculous returns?
Neither of those is true.
You can indeed increase the earning power of your portfolio through something called “leverage”.
But before I go on, just a note: while it’s true you can experience massive gains using leverage as I’ll explain in this post, it’s also true you can experience massive losses. If you know what you’re doing and take a few simple precautions, then it’s highly unlikely you’ll experience any untoward consequences, but this is somewhat akin to upgrading from a handgun to a high-powered rifle. You’re that much more likely to shoot yourself in the foot — and if you do, it’s going to leave a much bigger mark. But if you know how to protect yourself, then doing so is unlikely.
My Path to Using Leverage
What exactly is leverage? “Leverage” essentially means that you can use a smaller amount of capital to control a larger amount of stock.
Interestingly I found that this is very rarely discussed until you really get into investing circles. For the average investor just doing research on how to get started, you’ll just hear advice like “Invest in a broad-market ETF.”
I used to do that, too. Before really getting into investing, I had a Vanguard account with a few shares of VTI (the Vanguard Total Stock Market ETF). Any time I had a couple hundred to invest, I’d put it in there and buy another share of VTI.
Before even that, I had an account with Betterment, a robo-advisor that manages your investments for you, across a diversified series of ETFs. Not all that different from the above really.
But, while I felt like I was doing the responsible thing by investing, it just wasn’t all that exciting.
Some would argue, it shouldn’t be. They would say that investing is a long-term endeavor, and that if you add to your investment portfolio regularly, it would one day become big enough to support you in retirement.
But my dream has always been to have enough money so that I didn’t have to work a 9-5 job, and would have the freedom to do whatever I wanted, whenever I wanted to do it.
There is a movement out there called “Financial Independence, Retire Early” (FIRE), which on the surface has similar goals. People aim to retire as early as possible, like in their 30s or 40s.
So I got pretty heavily into that mindset for a while. But an issue quickly became apparent.
Proponents of FIRE essentially cut out most joys of life now, in exchange for being able to retire early. They become super frugal, trying to live on 50% or less of their income.
The idea is that if you work super hard at making a lot of money and denying yourself for 10 years, then you can spend the rest of your life doing what you want.
Actually not really, because most FIRE proponents still advocate being frugal even after their early retirement. So we’re not talking about a retirement full of traveling around the world, or having a lot of nice things.
After all, the more frugal you are in retirement, the less you need to live on, so the less you need to save up ahead of time.
And then this ultra-frugality is seen as some kind of virtue, as though wanting to enjoy life was just succumbing to the temptations of capitalism ?. I know, unthinkable, right?
Well, I was pretty sure that if I tried to do that, I’d have a mutiny on my hands by way of my wife. Plus, I enjoy the nicer things of life myself, and couldn’t see myself slaving away for 10 years just to, you know, still not live any better off.
That seemed like the hard way. And I’ve found that where there’s a hard way, there’s almost certainly a far easier way.
I started looking into more active trading of individual stocks. I came across some stock services that promised to beat the market, which looked to be the kind of thing I wanted.
This started me on the path of learning about leverage. I opened up a real brokerage account with TD Ameritrade, and started seeing what features were available. I learned a lot more about all different types of investments and investment styles.
And in my research I found two features that looked like they could help: margin, and options.
With these two forms of leverage, I could potentially control a far greater amount of stock than the size of my portfolio would normally allow for. That seemed to be exactly the kind of thing I had been searching for.
Two Types of Leverage
So as I alluded to above, there are broadly two types of leverage: borrowing on margin, and options trading.
Now that’s an oversimplification. There are undoubtedly more, such as trading futures, but I’m not going to discuss those here as this on its own could fill several volumes.
The first is margin. On the surface this initially seemed like a really dumb idea, but many, many people use it wisely to increase the potential return of their portfolio.
I’m not going to cover this at length because I prefer options as my main form of leverage, but I will give a brief overview.
Margin is essentially when you borrow money from your broker to buy stock.
Your “broker” is the account where you trade stocks. It’s called your “brokerage” account because it enables you to make trades, and the “broker” will execute those trades for you.
So let’s say you have a $5,000 portfolio and want to invest in my latest stock recommendation, Perficient, Inc. Perficient (NASDAQ: PRFT) closed at $52.19 yesterday, so with $5,000, you could buy 95 shares of the stock.
Now from there, if tomorrow the stock went up 1%, your portfolio would go up to $5,049.40. A near $50 gain in one day isn’t half bad, right?
But let’s say you’d like to make even more, because of course you would. ?
So your brokerage lends you $5,000 (yes just like that). Now you have the ability to purchase 191 shares of PRFT ($5,000 of your cash, plus $5,000 borrowed from the brokerage, divided by the closing price of $52.19).
Now what happens if that goes up by 1%? Your portfolio value now goes up to $10,099.32, including the margin loan from the broker.
Subtracting that, your real portfolio value is $5,099.32, a nearly 2% gain over your $5,000 investment.
That might not seem very impressive, but let’s extend the example out. Let’s say in 1 month, PRFT has gone up 20% to $62.63. Without margin, buying 95 shares as above, your portfolio would now be worth $5,991.80. But with margin, now able to buy 191 shares, your portfolio value (excluding the margin loan) would be $6,994.04.
So they’ll just lend you money, just like that?
Pretty much, yeah. There are limitations of course, and they will charge you an interest rate on that margin, but it works pretty much exactly as I discussed above.
What’s the risk? Why isn’t everyone going out and doing this?
The risk is that the stock drops. Let’s say that same investment of PRFT goes down 20%. With just your own money, you’d experience a loss of $991.80. But with the margin loan, you’d lose a total of $1,994.04. that’s out of your own money, and you still have to pay back the margin loan to the broker.
But, you can hopefully see how powerful margin can be. You can essentially double your gains without any additional outlay of cash.
There’s another way of using margin as well, which is called shorting.
Shorting is when you think a stock will go down. The normal course of investing is that you buy a stock, and try to sell it at a higher price. But when you short, you turn this around on its head: you sell the stock, then hope to buy it back at a lower price.
How’s that work? You’re basically borrowing that stock from the broker, instead of borrowing cash as above. You then sell that stock on the market. Then when it goes down, you buy the stock back and pay back the broker, keeping the difference yourself.
It’s a great way to profit off of a bear market (when the market is trending downwards). But the danger is that the stock rises. You then have to buy it back at a higher price than you sold it at.
Again, not a ton of detail, because it’s not my primary focus. I don’t short stocks at all (you can get the same effect with certain options strategies as discussed below), and I use margin sparingly when I want some extra leverage on a stock, such as around earnings dates.
Options have always fascinated me, though for much of my time investing, I had no idea what they were. They sounded super complicated, like a totally different world of investing. But now I use them every day, to make up to 50% profits and higher in a matter of hours or days. Just yesterday I made over 100% on a Tesla (NASDAQ: TSLA) option, making $800 within about 30 minutes.
The first thing you need to know about options is that they are what is called a derivative. That means that when you buy and sell options, you aren’t actually buying and selling the underlying stock. An option is a derivative because its price is based on the price of the stock.
For example, if I buy an option for PRFT, I’m not actually buying PRFT itself. I would not own any shares of PRFT.
So what on earth does it mean to buy an option, then?
It’s actually very simple. The owner of an options contract (the one who bought the option) has purchased the right (but not the obligation) to buy or sell a given stock at a given price, on or before a given date. In other words, you have the option (thus the name) to buy or sell that stock.
Why on earth would you want to do that? This seems rather convoluted, no?
The Milk Metaphor
Let me use a metaphor to explain. Let’s say that you go to the store and see that a gallon of milk is $3.00. However, you have reason to believe that it will soon be going up to $4.00. Maybe a sale is coming to an end or something.
You don’t need milk today, but don’t want to lose out on the sale price. So you go up to a cashier and say, “I’d like the right to buy this milk at $3.00. If I pay you 25¢, can you give me a coupon to come back later and buy the milk at that price?”
Now of course this would never happen. But if it could, it’d be pretty helpful for you, right?
So the cashier agrees, you hand over a quarter and she gives you a coupon. She says you can use that coupon up to a month from the current date. After that, it’s worthless.
Then two weeks later you need milk, but it now costs $4.00 as you predicted. So you come back, show your coupon, and buy the milk at $3.00. You’ve exercised your right to buy that milk at the agreed-upon price, within the agreed-upon timeframe.
Now yes you had to pay 25¢ for the right to buy that milk at the agreed-upon price, but that brought the total price up to $3.25, far below the $4.00 it was selling for when you returned.
But what would happen if you came back in two weeks and the milk was selling for $2.00? Your coupon would essentially be worthless. Sure you could still use it and buy the milk for $3.00, but why would you? You’d throw the coupon away and buy it at the cheaper price. The 25¢ was essentially wasted, but it was worth the insurance of being able to buy milk at or below your desired price.
That’s essentially how options work. But let’s add one more component to our metaphor, to illustrate one other point.
Let’s say you decide you don’t want milk at all. But you see the milk has gone up to $4.00 and you get an idea. You go to a friend and say, “Hey I have this coupon that will allow you to buy milk for $3.00. How much will you pay me for it?”
And that friend might pay you 50¢ for the coupon. After all, he’d still be saving 50¢ on the milk in total ($3.00 for the milk plus 50¢ for your coupon). And you, you’ve made a 100% profit, receiving 50¢ for the coupon you paid 25¢ to obtain.
That, in short, is the options market for you. It allows you to buy and sell the right to trade a stock at a given price, on or before a given date.
Specifically we’d call this a “call option”. A call option gives you the right to buy a stock at a given price. The seller of the call option is obligated to sell the stock to you for that price, should you wish to exercise the option.
The other type of option is called a “put option”. It’s the exact inverse of this. It gives you the right to sell a stock at a given price.
This might stretch the milk metaphor a bit, but let’s say you own a gallon of milk. Milk currently goes for $3.00 but you think it’ll go down, and you’re not going to use it yourself so you’d like to sell it. But you want to guarantee you can get $3.00 when you want to sell it.
Your friend, though, thinks it’ll go up. So you offer to pay him 25¢ for the right to sell the milk to him for $3.00 within the next two days (because that milk won’t stay good forever — this really is stretching this metaphor but I’m too far in to stop now).
Now two things could happen:
- The cost of milk at the market could go down to $2.00. But your friend agreed to pay you $3.00, so you sell the milk to him for that price. You spent an extra 25¢ to secure that option, but you still profited. But your friend lost out because he’s now paid $3.25 for milk that he could have bought for $2.00.
- Alternatively, the milk could go up to $4.00. Your option is worthless because you’re not going to sell it for $3.00 when you could go sell it for $4.00. Your friend is happy because he kept the 25¢ you paid him.
The True Power of Options
So that’s a pretty cool feature, isn’t it? If I think a stock will go up, I can secure the right to buy it at a lower price. That’s called a call option. Or if I think it’ll go down, I can secure the right to sell that stock at the higher price. That’s a put option.
Or, I can never touch the underlying stock itself, and just buy and sell contracts, as I illustrated earlier. It’s all up to you.
That would be cool enough on its own, but now let’s discuss the true power of options:
You aren’t just buying the right to buy or sell 1 share of a stock. Every options contract gives you the right to buy or sell 100 shares of that stock.
Yes, 100. That means that all the prices you see when looking at options chains (the options available to buy or sell) must be multiplied by 100.
So now let’s give some real examples.
Returning to PRFT, let’s say you believe it’s going to go up. So you buy a call option that allows you to buy 100 shares of PRFT for $50, by March 20.
There are several parts to this call option:
- Underlying: The stock that the option is derived from. In this case, PRFT.
- Strike price: The price at which you would like to buy the underlying stock, or that you believe its price will remain above. In this example, $50.
- Expiration: How long you have to exercise that option (or sell it to someone else). In this case, March 20.
- Premium: The cost to buy that option. In this case, that option is currently going for $3.85.
- Breakeven: The price that the stock must reach to guarantee profit. For call options, it’s the strike price plus the premium. In this case, $53.85 ($50 strike + $3.85 premium).
Now remember that that contract is for 100 shares. That means if the premium is $3.85, you have to spend $385 to buy that option.
That might seem like a lot at first, but keep in mind that you’re controlling 100 shares of that stock. Essentially, with only $385, you are controlling $5,000 worth of PRFT ($50 strike ✖️ 100 shares).
Now that’s leverage! Remember with margin you could only control up to twice as much stock as your cash would allow for. Here you are controlling far more.
So let’s continue the example. Let’s say by March 20, PRFT is trading for $60. Your option is for 100 shares, so that’s $6,000.
At this point your option will be worth about $10 ($60 price – $50 strike). You’d have two choices:
- Exercise the option for $50 a share, then turn around and sell it for $60 a share.
- Just sell the contract, making $10/share without ever touching the stock.
Most people choose to just sell the contract, unless they’d like to actually own the stock for some reason.
So if you sell it for $10, but bought it at $3.85, you’ve made a profit of $6.15. Of course that’s for 100 shares, so you’ve made $615.
In this example, you’ve turned an outlay of $385 into $1,000 within a month, a 160% profit. Not bad, right?
But to see the true power of it, let’s say you use your entire $5,000 portfolio to just buy PRFT call options. This wouldn’t necessarily be wise, as you’d want to diversify, but it’s just to illustrate.
So instead of buying 95 shares of PRFT, you buy 13 $50 contracts for $385 each. That means you control 1,300 shares.
Now if PRFT goes up to $60, the 95 shares would be worth $5,700.
But (ready for this?) the 13 contracts of PRFT would now be worth $13,000.
OK, here’s a table to compare buying PRFT with cash-on-hand, buying with margin, and buying call options.
|Using Cash||Using Margin||Using Options|
|Value After Price Increase||$5,700||$6,460||$13,000|
Now of course, this doesn’t come without risk. What happens if the price of the stock goes down? Let’s say it goes down to $40 by March 20.
Well, now your option is worthless. After all, you’re not going to exercise the right to buy PRFT at $50 when you could buy it at $40. The $385 per contract is lost. Yes, that’s a 100% loss.
Now if you bought 13 contracts of PRFT as I mentioned above, then all $5,000 is lost. Ouch.
I know that sounds scary, but it’s not usually so bad. You would keep an eye on the stock, and if you see it’s headed downwards, you’d sell your option before it became worthless.
So if you’re 1 week in and PRFT is trading at $48, there will still probably be people willing to buy a call option at $50. You’ll get less for it, maybe $2 per contract instead of $3.85, but you wouldn’t lose everything.
However, it is true, the potential losses are far, far greater than just trading the individual stock. It takes serious discipline to sell when your option is losing value, or to take profits when it’s gone up significantly.
So to summarize options, here are your possible moves:
- Buy a call option: Gives you the right to buy the stock at a given price. Used if you think it’ll go up.
- Sell a call option: Creates the obligation to sell the stock at a given price if the buyer exercises the option. Used if you believe it’ll go down.
- Buy a put option: Gives you the right to sell at a given price. Used if you believe it’ll go down.
- Sell a put option: Creates the obligation to buy at a given price. Used if you believe it’ll go up.
There’s far, far more to it. These options can be mixed and matched to create spreads and other strategies that can profit in any market condition.
The great thing about options is that they can be used no matter what the stock is doing. Whether it’s going up, going down, or not moving much at all, you can create an options strategy to profit, assuming you’re right about where the stock is going.
This is just a very surface-level coverage of this powerful trading instrument. There’s much more to it, but I only wanted to cover the basics here.
But hopefully you can see the power of them. Like I said, I use these every day to make massive profits. It’s not uncommon to make $1,000+ in a day, while only putting a few thousand on the line.
Yes, it’s risky. But if you think about it as it truly is — as a form of controlling 100 shares of a stock — then the risks become clearer and easier to avoid.
I will definitely go further in depth into options in the future, but hopefully this gives you an understanding of the basics. But feel free to ask any questions in the comments and I’ll be happy to answer.