Penny Stocks, Options and Trading on Margin

At its best, investing in penny stocks can be an exciting, lucrative endeavor. In most cases, a good strategy is to maximize the leverage of the invested capital by buying as many shares as possible. A move of only a few pennies when multiplied by a large position can equal a substantial gain in a relatively short period of time. Additionally, penny stocks can have lower trading volume than many listed options, a lack of liquidity which might present additional trading difficulties.

As investors become more sophisticated they turn to products such as options as a method for increasing the amount of leverage in a position. Given the lure of penny stocks and options it's natural for an investor to try and combine the two. Unfortunately, in the case of penny stocks, trading associated options is not possible.

Options on Small-Cap ETFs

While it may not be possible to trade options in specific penny stocks, it's still possible to use options to leverage the potential of the small-cap or micro-cap universe. One popular product for trading small-cap stocks is the iShares Russell 2000 ETF (IWM). For those unfamiliar with this product, IWM seeks to track the investment results of an index composed of small-cap U.S. equities.

Let's look at a historical example: Over the twelve months ending Sept. 23, 2014, IWM returned 17.62%. While it isn’t possible to trade options in many of the components, it's possible to trade options on the ETF itself. Small moves in the underlying ETF generally translate to significant movements in the options. One of the biggest benefits of trading options in small-cap ETFs rather than the stocks themselves is that it removes much of the company-specific risk.

Margin Accounts

Another method for increasing leverage to penny stocks is to set up a margin account. This type of investment account gives investors access to additional capital based on leveraging capital and securities existing within the account. Essentially this is the equivalent to borrowing money from your broker, using existing cash and securities as collateral, and then paying interest on the borrowed money for the right to use capital for buying and selling shares.

While trading on margin provides investors with additional leverage, it can be extremely risky. Using money that you don’t have for the purpose of buying any kind of stock is frowned upon by many, and if not used correctly, can lead to financial ruin. A good rule is to tread lightly whenever using margin or leverage of any kind to buy financial assets.

The Bottom Line

Buying penny stocks with cash can be a risky maneuver. That said, there are some traders out there that would like to increase their leverage to penny stocks even more by using products such as options. Unfortunately, in the majority of cases, options are not available for trading penny stocks. However, some risk-tolerant traders can turn to options on exchange-traded funds as a workaround. Some traders may even use the benefits of their margin accounts when trading penny stocks, but this should be considered a last resort and used with extreme caution.