Monday, March 11, 2013

What is Margin?

Using margin is a topic that I understood the very basics of but not enough to be able to try and use.  I hope this primer will help you out because I know it aided in my understanding.  My main goal for using margin would be to sell more put options, i.e. naked puts, since I wouldn't have to only sell cash secured puts.  A naked put is simply a put option where the cash doesn't have to be in the account to ensure that you can pay for the shares should the option be exercised.  By using margin I wouldn't be required to hold the cash in the account and could sell more puts which I feel is a winning strategy since some 75% of options expire out of the money.  Although that's a very debatable topic for some other post.

An Overview of Margin

Margin is essentially a line of credit that is extended to you by the brokerage that you can use to buy more stock than you could in just a cash account.  For example, if you have $5,000 to invest and are using a margin account with a 50% requirement you could buy up to $10,000 worth of stock.  For example, if there's a stock you want to buy worth $100 per share, you could only buy 50 shares with your cash.  However using margin would allow you to buy up to 100 shares.  That's simple enough.  The issue then comes when the price of that stock begins to change.

If the share price increases to $125, your account is now worth 100 shares x $125 = $12,500.  That $12,500 isn't all yours though since you borrowed $5,000 to purchase the shares, backing that out means your stake or equity is $12,500 - $5,000 = $7,500.  Based on your cash that's invested that's a 50% return instead of a 25% return that you would have received from using your cash alone.

If the share price decreases to $75, your account is now worth 100 shares x $75 = $7,500.  Backing out the margin again means that your equity is $2,500.  So a 25% loss in the stock means a 50% loss for you.

Both of the above calculations are ignoring commission and interest.

As you can see, margin will magnify the return both positive and negative.  There is also maintenance margin which is the amount of equity, whether cash or stock value in the account, much cover a certain amount set by the brokerage.  This can range from 25% to 40% depending on the broker.  So in the above example of the stock declining, your equity must cover 40% of the margin meaning the $5,000 (margin) x 40% <= $2,500 (equity).  If the stock falls sufficiently enough to cause your equity to be less than the maintenance margin, a margin call is triggered.  Depending on the brokerage you might have to deposit more cash or they could sell some of your shares without your consent to bring it back to level.

Margin Interest

In order to calculate the interest that you'll be charged the equation is fairly simple.  The equation is as follows:

(Interest Rate / 365 days) x (Amount Borrowed) x (Number of Days Borrowing Funds)

To determine what you owe we have to go back to the equity calculation from above but rearrange it.  The equation becomes Equity - Market Value = Margin.  If the amount is zero or positive then you owe nothing. However, if it's negative then you plug that into the equation as the amount borrowed to calculate the interest that you would owe.

Selling Naked Puts

Naked puts are when you don't have the cash on hand to secure the put option.  This allows you to sell more put options since the up front cash isn't required.  The great thing about selling naked puts in a margin account is that you don't have any interest charges unless you are assigned more shares that you have capital to pay for.  You would then use margin to purchase the shares if you were not able to deposit more cash to that account.

For example, I've been looking at selling a $36 strike put on Wells Fargo (WFC).  By selling a cash-secured put I would have $3,600 sitting in my account waiting until the options expires to ensure that I have the capital to purchase the shares on expiration.  That $3,600 could be put to better use either in my brokerage account or the margin account to help cover more share purchases if the put options were assigned.  I'll run through an example using my brokerage's, Fidelity's, requirements.

Their requirement for equity puts are the greater of:

(1) 25% of the underlying stock value plus the premium received minus amount out of the money
or
(2) 15% of the strike price plus the premium

I'll run through the calculations to show how much cash was needed in a margin account rather than the cash secured basis.  On March 8, 2013 WFC was trading at $36.58.

Calculation (1) is as follows:

25% x $36.58 + $2.17 - ($36.58 - $36) = $10.735

Calculation (2) is as follows:

15% x $36.00 + $2.17 = $7.57

Since the margin requirement calculations above are on a per share basis and one option contract represents 100 shares, we multiply $10.735 x 100 = $1,073.50.  This is the amount of cash I would need to have in the account versus the $3,600 required for the cash secured put.  This is significantly lower than the cash secured route which allows for more flexibility to sell puts.

When selling naked puts, you must be sure to avoid being over-leveraged in case a broad market sell-off happens when you have too many puts open.  If you have too many puts that get executed at once that could lead to you having to purchase the shares on margin triggering interest charges or margin calls should the value of the puts decline quickly.  I'm strongly leaning towards having margin added to my account but will not be leveraging myself anywhere close to the max.  I plan on essentially going the cash secured route by holding that much in the account to start off.

Have you or do you currently use margin with your brokerage account?  If yes, is it to purchase stock outright or just the ability to sell naked puts?

13 comments:

  1. Nice write-up. As you know, I use margin to be able to sell a lot more puts than I would be able to with just cash. As long as I meet the margin maintenance requirements I don't have to pay any interest. My goal is to leverage my ability to sell more puts in this ever increasing market and not paying any interest for using margin.

    The biggest drawback as you mentioned would be if there is a big market pullback. I'd be forced to immediately put more cash into my account or I could face margin calls.

    It's definitely not for the faint of heart but I've had a lot of fun trading options so far.

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    Replies
    1. AAI,

      Thanks for the help in the calculations. I actually just got margin approval and sold my first put with margin earlier today. I'll be posting about it tomorrow. I think the advantages are there with combining margin and naked puts but the black swan event is always lurking. In a ever increasing market like we've had thus far in 2013 can give some nice results.

      The key is to not over leverage yourself.

      Thanks for stopping by!

      Delete
  2. Very awesome article here,I really appreciate this article because the topic has been raised very interesting and written in very deep.

    ReplyDelete
  3. Nice write up JC. Once my funds increase and my confidence/knowledge improves this is something I will look at for my portfolio. I was looking at margin to purchase stock then do covered calls.

    One thing I don't understand though is if I brought stock on margin could I decide to pay back the "loan" at anytime without selling the stock?

    I need to find a virtual trading platform that covers margin if there is such a thing!

    ReplyDelete
    Replies
    1. Gareth,

      I think as long as it's used right, margin can be very useful. I would think all you would need to do is deposit more cash into the account to pay back the "loan". But I'm not an expert at all and it probably still depends on the brokerage.

      I mainly wanted the margin account so I could sell more puts. Having the margin act as the deposit is nice.

      No matter how you use margin, it's very important to monitor your account and not get overleveraged. I'd hate to be forced into selling some of my positions because the markets took a big drop forcing some margin calls.

      Thanks for stopping by!

      Delete
  4. Thanks for a good overview of margin. I have a personal rule against borrowing money to invest, so no margin for me. However, I acknowledge that margin can benefit some investors if it is used conservatively and wisely.

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    Replies
    1. DGM,

      I won't be using it to purchase stocks because that's just asking for trouble. However, using it to sell naked puts is more of a line of credit that hasn't been tapped. As the puts that I sell get closer to expiration and look like they might be expiring out of the money I can then sell other puts. The key is to not over leverage yourself and I plan on just barely using margin and essentially selling cash secured puts by having that money in the account to start with.

      Thanks for stopping by!

      Delete
  5. Nice explanation. I even created a spreadsheet calculating my margin and maintenance requirements for each trade I want to take to see if I would have enough maintenance to carry the trade. It helped me a lot in the past, since I am using margin a lot. Making money with other people's money!!!

    ReplyDelete
    Replies
    1. I'll be getting a spreadsheet put together for mine, of course it won't be too useful to others since the requirements vary across brokerages. I don't think I'll be using it to purchase any stocks, but just stick with the naked put route for now.

      Thanks for stopping by!

      Delete
  6. I have used margin on many occasions, mainly to buy equity positions. On the whole it has been greatly beneficial. I suffered some in 2008/2009, but i put that down to being greedy with margin. I don't think I could have created the wealth or dividend income I have today without it.My use of margin today is more for opportunistic purchases. If I don't have dividend income and there is a special opportunity, I deploy margin, and then repay once dividend income is sufficient to repay.

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    Replies
    1. Integrator,

      It can be very useful if used properly, but being overleveraged at the wrong time such as 08/09 can really hurt. I like that idea of using it for special situations to purchase but then keeping most of your cash invested. For now I think I'll be sticking with just selling naked puts but in the future that could change.

      Thanks for stopping by!

      Delete
  7. This was a great overview. I've been reading a lot about margin trading and may try to get margin and naked put selling privileges from my broker. I'm not sure if I'll be able to or not, I hope so. I think that a margin/put combo will make a great addition to my portfolio.

    ReplyDelete
    Replies
    1. MyFIJ,

      The naked put option is what I'm most excited about. I think as long as you have some option experience and the minimum equity value, mine was $25k for my brokerage, then it's fine. The margin/naked put is a great combination as long as you manage it well to see keep from being overexposed in case of a big market drop.

      Thanks for stopping by!

      Delete