More complex ways to invest in stocks

There are many ways to invest in stocks. You can buy stocks as part of your investment portfolio and sell when you decide the time is right. There are also more complex ways to invest in stocks. This includes short selling, buying on margin, stock options, and rights and warrants.

These types of stock investing are considered riskier. They can involve borrowing to invest. And they also can rely on specific assumptions about how a stock will or will not behave. Learn more about these complex forms of stock investing.

What is short selling?

Typically, when you buy a stock, you make money by selling it for higher price than what you paid for it. If you short sell a stock, you’re speculating that the price is going to fall. You can make money “short selling” a stock if its price does go down. But if the price goes up, you’ll lose money.

When you short sell a stock, you borrow shares from your investment firm because you think that the price of the stock is going to fall. You sell the borrowed shares at the current price. And if the price drops, you make money by buying the shares back at the lower price and then returning them to your investment firm. But if the price rises, you’ll have to buy back the shares at the higher price and lose money as a result.

You must have a short account to engage in short selling. A short account is a type of margin account.

These are the steps involved in short selling:

Borrow shares – usually from your investment firm.
Sell them – at the current price.
Buy them back – at a lower price and make a profit.
Return the borrowed shares – to your investment firm (called covering).

Because you don’t actually own the shares, you have to pay your investment firm any dividends that are declared during the course of the loan.

What happens if the stock price goes up instead of down?

If you’ve chosen to short sell and the stock price goes up, you’ll lose money if you have to buy back the shares at the higher price, and then return them to the investment firm.

Theoretically, there is no limit to how high the price of a stock could go — your potential losses could be catastrophic. This is the greatest risk of short selling.

Caution
Short selling is a riskier form of investing in stocks. There is no guarantee how a stock will behave. Also, your investment firm can require you deliver the shares to them at any time. You’ll have to buy back the shares at the current market price and return them to the firm.

What is buying on margin?

Buying on margin can mean potentially higher returns — but it can also lead to large losses very fast.

You may be able to borrow money from your investment firm to pay for part of your investments. This is called buying on margin. Buying on margin allows you to buy more shares than you would normally be able to afford. It’s a way of using leverage. This may mean potentially greater returns. But it also comes with greater risks — you can lose more money than you originally invested.

In order to start buying on margin, you’ll need to follow these six steps:

Open a margin account – You must open a margin account to buy on margin.
Know your minimum investment amount – The investment firm sets the minimum amount you must deposit in a margin account. This is sometimes called the minimum margin.
Know how much you can borrow – This depends on the price of the stocks you’re buying. Your investment firm may lend you up to 70% of the money you invest. This is called your maximum loan value.
Know your interest charges – The interest charges on the loan are applied to your account. Depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
Provide collateral for the loan – The stocks you buy are used as collateral for the loan. You have to keep enough assets in your margin account to cover the loan value at all times.
Prepare for a margin call – If your stocks drop in value, your investment firm may ask you to put more money into your account to maintain your margin. This is known as a margin call. If you don’t put in more money, the firm has the right to sell your stocks and other investments in your account to cover the margin call.

What are the risks of buying on margin?

You can lose more than you invested – If your investments go down in value, you still have to pay back your loan and interest. You may have to put up more margin to maintain your account. If you don’t, your investment firm can sell your investments to cover the margin call. You could lose more money than what you originally invested.
It costs more to invest – In addition to trading commissions, you have to pay interest on the loan. But depending on what you invest in, you may be able to deduct the interest on money you borrow to invest.
The interest rate can go up – The interest rate on your margin account can change at any time. It may cost you a lot more than you thought to pay back what you borrowed.

Read your margin account agreement
When you open a margin account, you sign a margin agreement. Read it carefully to understand how the stocks you buy serve as collateral for the loan, your responsibilities for repaying the loan and how interest is calculated.

How much you can borrow in order to buy on margin?

The Canadian Investment Regulatory Organization (CIRO) consolidates the operations of the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA).

CIRO oversees all investment dealers, mutual fund dealers and trading activity on Canada’s debt and equity marketplaces. In the past, IIROC, set the minimum standards based on the price of a stock. Your investment firm may impose more stringent requirements in certain situations.

Share price	Maximum loan value
Less than $1.50	No loan allowed
$1.50 to $1.74	20%
$1.75 to $1.99	40%
$2.00 or more	50%
Eligible for reduced margin*	70%

* Stocks with low volatility and high liquidity, making them easier to buy and sell

For example, let’s say you have $10,000 to invest and you want to buy shares of a company at $10 a share. Your investment firm agrees to lend you another $10,000 on margin. You invest the entire $20,000 in 2,000 shares at $10 a share. You agree to always keep $10,000 in assets in your account to cover this loan.

What happens next? Let’s look at two scenarios: if the stock goes up in value, and if the stock goes down in value.

Scenario 1: The stock rises to $12 a share

You sell the shares for $24,000 – a 40% return on your original $10,000 investment. If you had paid cash for the shares, you would have made $2,000 on your $10,000 investment or 20%.
You pay back the loan and interest and pay trading commissions to your investment firm.
After costs, your profit would be still higher than if you had invested without borrowing.

Scenario 2: The stock drops to $8 a share

Your investment falls to $16,000 and you have a loss of $4,000 on paper. You could sell the shares and take the loss, but you decide to hold onto them in the hope that they may go up again in the future.
You must keep paying interest on the loan.
You also have a margin call. That’s because your investment firm is only allowed to lend you up to 50% of the current market value of your investment. Since your shares are now worth $16,000, you can only borrow $8,000 on margin. Your current loan is $10,000, which means you’ll have to add $2,000 to your account to make up the difference and maintain your margin.

Warning
Buying on margin can be very risky — you can lose more money than you originally invested. Read your investment firm’s margin disclosure agreement to understand all the risks involved.

What are stock options?

A stock option is a contract that gives the buyer the right — but not the obligation — to buy or sell a stock at a specific price on or before a certain date.

Stock options are known as derivatives because they derive their value from an underlying asset.

You don’t have to invest directly in the stock. You can just buy the option. One option usually gives you the right to buy or sell 100 shares of a stock.

There are two types of options:

Call – You buy a call option when you believe the price of the stock is going to rise.
Put – You buy a put option when you think the price is going to fall.

1. Call options

Call options give you the right to buy a stock at a certain price by a certain date. You buy call options if you think the price of the stock is going to rise.

You make money if you:

Sell the option for a higher price than you paid for it, or
Exercise your option to buy the stock and then sell it at a higher market price.

If, at the expiry date, the option is in the money (the market price of the stock is higher than the exercise price) and you don’t exercise the option, it will be exercised for you. If the option is out of the money, it will expire worthless.

For example, let’s say you buy a call option on XYZ Inc. for $3.

The share price of company XYZ Inc. is at $40, so your call option allows you to buy shares at $40 until the end of next month.
Meanwhile, the share price jumps to $50.
You exercise your option by buying the shares at $40 and then selling them at the current market price of $50.
You’ll make $7 a share — the difference in the share price less the $3 premium for buying the option (less any commissions).

2. Put options

Put options give you the right to sell a stock at a certain price by a certain date. They’re often used as a hedging strategy. You buy a put option if you think the price of a stock, you own is going to fall. If the stock rises in value, you can sell your shares for a profit and let the put option expire. But if the price falls, you can exercise the put option and sell the stock at the higher price specified by the put option.

You can also make money if you sell the option for a higher price than you paid for it.

Keep in mind these key terms to help you understand stock options:

Call (or put) holder – Someone who has bought a call (or put) option.
Call (or put) writer – Someone who has sold a call (or put) option.
Expiry date – The date after which the option can no longer be used or exercised.
Option premium – The price of the option.
Strike price – The specified price at which the holder of the option can buy or sell the stock.

What are rights and warrants?

Like stock options, rights and warrants give common shareholders the right to buy more shares at a certain price by a certain date:

Rights – Are issued to get investors to buy more of a company’s stock by a certain date. The company usually offers them at a price lower than the market price. Rights tend to expire after a few weeks.
Warrants – Are mostly offered to attract investors when a company issues new stock. They tend to have a longer period before they expire, usually a year or two.

Rights and warrants typically trade on an exchange. They can produce large gains if the stock price goes up by even a small amount. But they can also be risky because they are a type of leverage.

Key point
If you hold a right or warrant and don’t give instructions to exercise it, it will expire worthless.

Summary

There are more complex ways to invest in stocks, including:

Short selling – Borrowing shares from your investment firm because you think that the price of the stock is going to fall. If you short sell a stock and the price goes up, you lose money.
Buying on margin – Involves borrowing money from your investment firm to pay for part of your investments. It allows you to buy more shares than you would normally be able to afford.
Stock option – A contract that gives the buyer the right — but not the obligation — to buy or sell a stock at a specific price on or before a certain date. The two types of options are: call and put.
Rights and warrants – give common shareholders the right to buy more shares at a certain price by a certain date.

These types of stock investing are considered riskier.