No. of Recommendations: 25
A DITM call, is darn close to buying shares on margin. The advantages of the calls over actual margin is:
1) often the implicit interest rate using the call is lower than the actual interest rate using margin
2) You don't even in theory have to worry about "margin calls" causing your losses to go through the roof. Using calls instead of buying stock on margin limits your possible losses to "only" everything you invested in the call.
Hmm, I think the emphasis in the analogy is perhaps a bit off.
It's a bit like saying an aircraft is basically a type of car.
(Except that it flies)
The difference about margin calls is the key salient difference between the two, and makes them night and day situations in terms of risk, which is what is important here.
A much better analogy is that buying (in the money) calls is much like getting a two year fixed rate open mortgage to pay for some fraction, say half, of a stock purchase.
The similarities:
The mortgage loan can't be called no matter what happens to the price for the stock, nor the mood of the lender.
In two years, you will either have to come up with the money, or get a fresh mortgage for another couple of years, or of course sell the stock to pay off the debt.
Such a new mortgage might not be available, but very probably will be.
The new mortgage might be at an interest rate you can live with, or might be expensive.
It's an "open mortgage": you can repay it any time by closing your position.
In both situations, the stock might go up or go down, so you might win or lose money. This is a property of the investment side of things, not the debt side.
No analogy is perfect. The limitations of this one:
If you buy calls, you don't have to make any mortgage or interest payments.
If you buy calls, you don't have to own a house or any other asset to use as security to get the loan, and don't have any income requirement to qualify.
If you buy calls, the "loan" does not encumber any other asset...in the analogy, it's as if the lender doesn't register a lien against the property, nor even care if you already have a mortgage or two against it.
In the case that you close for a loss, the maximum loss is the amount you did NOT finance, not the total amount of the stock purchase.
As an aside, I find the cost of "borrowing" using calls is typically higher than the rates at which I could borrow elsewhere, not lower.
But the advantages above make all the difference.
Jim
