Give me a lever long enough and a place to stand and I will move the entire Earth
– Archimedes
Whether you examine the property portfolio of a real estate tycoon or the portfolio of a successful private equity company, you will find a common thread that magnifies returns for each… leverage! It is no different in the stock market. In fact, each of us who trades options takes advantage of the leverage they afford us every day.
2. You CANNOT use margin to purchase options but there are MARGIN REQUIREMENTS for certain spread positions that we like to take.
Stock Buying Power: $200,000
Option Buying Power: $100,000
The benefit of margin is obvious but it doesn’t come without drawbacks. Had the stock dropped by 50% from $100 to $50, the $200,000 would have turned into $100,000 and since $100,000 was borrowed, the broker will issue a margin call and take back its $100,000 leaving us with $0! Hence, both the risks and rewards are magnified if we fully use margin under the current system.
Margin Calls
Despite its potential rewards, buying on margin can be very risky. For example, the value of the stock you buy could drop so much that selling it wouldn't raise enough to repay the loan.
To protect brokerage firms from losses, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) require you to maintain a margin account balance of at least 25% of the market price of any stock you buy long, to hold in your account. Individual firms can require a higher margin level, say 30%, but not a lower one.
If the market value of your equity falls below its required minimum, the firm issues a margin call. You must either meet the call by adding money to your account to bring it up to the required minimum, or sell the stock, pay back your broker in full and take the loss. For example, if shares you bought for $10,000 declined to $7,000, your equity would be $2,000, or only 28.6% of the total value. If your broker has a 30% margin requirement, you would have to add $100 to bring your equity to $2,100, or 30% of $7,000.
You can readily see that for the broker to lend us money to trade options would be a very high risk venture on their part since the options can move by such huge percentages each day and your broker is only in the business of issuing margin in order to benefit from the interest you are paying.
Interest Charged on Margin Balances
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$0 – $49,999 8.75% -
$50,000 – $99,999 7.75%
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$100,000 – $249,999 7.50%
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$250,000 – $499,999 7.25%
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$500,00 – $999,999 7.00%
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Over $1,000,000 6.50%
This is critical information to be aware of. If you are not completely confident that you can generate a return greater than 8.75% on a borrowed capital less than $50,000 or 7.25% for example, on borrowed capital of $250,000 – $499,999 then margin is not yet a prudent choice. However, once you have proven to yourself that you can consistently and competently generate returns of greater than 8.75% then it is a smart decision to exploit margin as fully as possible. Just like the real estate tycoon or the corporate raider, we too can magnify our returns using borrowed capital.
Margin Debt
In 1929, the stock market crash was blamed on extensive speculation and excessive leverage, including margin buying. Following a crisis in the financial industry that left failed brokerages and devastated investors in its wake, the Federal government created the Securities and Exchange Act of 1934, separating the banking and securities industry, and giving the Federal Reserve Board the authority to set margin requirements, which it subsequently did through Regulation T.
The dangers of margin can be seen in this article “The Fear At The Margin”
The new formulas are designed to more accurately assess an investor’s risk by putting all of the positions in the same underlying stock in one portfolio and then stress-testing that portfolio for a 15% move higher or lower in the stock.
This makes much more sense when you think about the risk you actually assume in your virtual portfolio on certain positions.
Protective Put Risk = Total Cost Basis – Long Put Strike
Total Cost Basis = $124.61 + $30.10 = $154.71
Risk = $154.71 – $140 = $14.71
So, our virtual portfolio margin requirement is approximately $1,471 assuming a 100 share purchase and 1 long put contract purchase. That’s a $15,471 investment that only has an $1,471 virtual portfolio margin requirement! The power of this is really evident by interpolating to bigger numbers. A $154,710 investment has simply an $14,710 virtual portfolio requirement!
The Chicago Board Options Exchange (CBOE) have listed a number of different strategy examples and their accompanying portfolio margin requirements here.
Some are listed below:
These are old samples NOT recommendations!
COVERED WRITE
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Long 500 IBM @ $91.25
- Short 5 calls IBM APR 95 @ $ 2.78
Virtual Portfolio margin requirement is $5,504.00.
PROTECTIVE PUT
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Long 500 IBM @ $91.25
- Long 5 puts IBM APR 90 @ $ 2.50
Virtual Portfolio margin requirement is $1,878.03
DEBIT SPREAD
· Long 50 calls IBM APR 90 @ $5.45
o Short 50 calls IBM APR 100 @ $ 1.16
Virtual Portfolio margin requirement is $19,089.00
NON-CONFORMING DEBIT SPREAD (Long must expire on or after short)
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Long 50 calls IBM APR 90 @ $5.45
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Short 50 calls IBM JUL 100 @ $2.28
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Short 50 calls IBM JUL 100 @ $2.28
Virtual Portfolio margin requirement is $14,106.00!
LONG CONDOR
· Long 50 calls IBM APR 85 @ $8.99
o Short 50 calls IBM APR 90 @ $5.45
· Long 50 calls IBM APR 100 @ $1.16
o Short 50 calls IBM APR 95 @ $2.78
Virtual Portfolio margin requirement is $6,221.00.
NON-CONFORMING LONG CONDOR (All options must expire at same time)
· Long 50 calls IBM APR 85 @ $8.99
o Short 50 calls IBM JUL 90 @ $6.82
· Long 50 calls IBM APR 100 @ $1.16
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Short 50 calls IBM JUL 95 @ $4.12
Virtual Portfolio margin requirement is just $4,638!
Does Your Broker Offer Portfolio Margin?
Impact of Portfolio Margin
While the overall impact of portfolio margin is still to be fully determined after its first full year, we already see an increase in overall option activity, leading to a much higher VIX as well as an increased demand for longer term long put options. By purchasing relatively inexpensive (on a per day basis) longer term long put options, traders can now fully protect their stocks with minimal portfolio margin requirements. Trades that originally seemed conservative, such as our KMP-style trade (which we will revisit in another post), become increasingly attractive as we can not only hold a low risk position but also benefit from the cumulative effect of short call premiums on a regular basis.
We want to take full advantage of products that allow us to make sensible use of maximum leverage. We may not be able to move the entire Earth but I think we can have quite an impact on our virtual portfolio!
Have a fantastic week!