In real estate investing, the concept of leveraged investing is well known and documented in such best-sellers as Robert G. Allen’s Nothing Down for the 2000s and Michael A. Lechter’s OPM (Other People’s Money). The idea of generating profit while using little or none of your own money down is enticing and exciting. It actually does make sense in certain scenarios. For example, when you own an investment property, you are using “OPM” as your tenant is paying off the mortgage. When it comes to the stock market, the use of options is a great example of leveraged investing. The option buyer (not us) is controlling shares of stock at a greatly reduced cost.
When we write covered calls, we are using the cash generated from the call premium sale to either reduce our cost basis or to take the profit and re-invest it, thereby compounding our profits instantly (the next trading day or T +1, in the case of options). There is another way to leverage our covered call investments and that is to trade in a margin account.
Margin Account:
This is a brokerage account where the client has the ability to borrow money from the broker to purchase securities. This loan is then collateralized by the cash and securities in that specific account. Both gains and losses can be magnified via this form of leverage. If and when the value of the security drops to a certain level, the investor will be required to put additional cash in the account or sell certain securities. This is known as a margin call. You are only allowed to borrow money to buy certain securities called marginable securities. You cannot buy options on margin. However, when writing covered calls you can borrow money for the first leg of the trade which is the purchase of the security.
Interest a factor:
When money is borrowed from our broker in a margin account, interest is charged and needs to be calculated into our results. This expense is known as the Cost to Carry and should be more than compensated for since the cost to borrow ranges between 5-9% per year and educated covered call writers should easily beat that in normal market conditions.
How much can I borrow?
According to Regulation T, the SEC has set the maximum borrowing power to purchase a stock @ 50% of the lower of these two:
- Current stock price
- Call’s strike price
In addition to the 50% rule, the cash generated from the option sale will reduce the amount of cash required to enter the position.
Example of margin in a covered call trade:
Buy 200 x BCI @ $40 = $8000
S-T-O 2 x $40 calls @ $2 = $400
Next, let’s feed this information in to a margin calculator (http://www.cboe.com/tradtool/mCalc/default.aspx):
Margin Calculator
Margin Calculator
As you can see, the amount of cash required to invest is reduced from $8000 to $3600 by taking 50% of the $8000 and then subtracting the $400 generated from the sale of the short call. Let’s assume our shares are assigned and calculate our returns with and without margin:
Cash Account:
ROO = $400/$8000 =5%, 1-month return
Margin Account:
We will assume a 9% interest charge on the $4000 loan. This results in a 1-month debit of $30 ($4000 x 9%/12).
ROO = $400 – $30/$4000 = 9.3%, nearly doubling the returns from the cash account. Notice that I didn’t deduct the $400 premium from the cost basis ($4000) because in the BCI system we stress taking the profit and re-investing it and thereby compounding our money instantaneously. Either way is correct as it is simply a different philosophical approach to the strategy.
Maintenance Margin:
Once a stock has been purchased on margin, the Financial Industry Regulatory Authority (FINRA) requires that you must maintain a minimum amount of equity in the margin account.
Equity = Share Value – amount borrowed
This minimum amount is set @ 25% and is referred to as the maintenance requirement. Many brokerages choose to have requirements between 30-40% but it cannot be less than 25%.
Maintenance Example:
- Buy 200 x BCI @ $40 = $8000
- Borrow $4000 in a margin account
- Market value of shares drop to $5000
- Equity falls to $5000 – $4000 = $1000
- A 25% maintenance requirement would be $5000 x 25% = $1250, leaving a shortfall of $250 ($1250 – $1000)
- Had the maintenance requirement been 40% of $5000 or $2000, the shortfall would be $1000
- A shortfall will trigger a margin call where the investor would be required to add cash to the account or sell stocks. It is possible that your broker can take it upon himself to sell some of your shares without notifying you with a margin call.
Minimum Margin vs. Initial Margin:
Minimum margin is FINRAs requirement that we deposit at least $2000 or 100% of the purchase price, whichever is less. Some firms may require more.
Initial margin is set forth by Regulation T of the Federal Reserve Board and currently allows up to 50% of the purchase price of marginable securities.
Disadvantages of Margin Accounts:
- You may have to deposit additional cash or securities in your account on short notice to cover market losses
- Your brokerage may sell some of your shares without consulting with you to pay back the loan
- You may be forced to sell some of your securities to compensate for falling share price
- You can lose more money than you invested as risk is enhanced
Conclusion:
Margin accounts are a form of leverage which can magnify investment results dramatically in both directions. I would only advise the use of margin accounts when writing covered calls for experienced, savvy investors with a successful track record.
Market tone:
This week we have seen a temporary setback in the market assuming our representatives finally elevate the debt ceiling and ensure a AAA rating of US Treasury debt. At that point the market should recover and focus can return to creation of jobs which will further enhance the sluggish recovery. Reports this week were mostly negative but not frightening:
- GDP grew at a sluggish 1.3% in the 2nd quarter which represented an increase over the (revised down) 0.4% from the 1st quarter
- The Federal Reserve’s Beige Book survey showed that economic activity moderated in all 12 districts
- New orders for US durable goods declined by 2.1% in June, offsetting May’s 1.9% increase
- Employment costs rose 0.7% in the 2nd quarter
- Growth in wages and salaries remained steady @ 0.4%
- The Conference Board’s index of consumer confidence rose for the first time since April and bounced off its lowest level since late last year to 59.5 in July
For the week, the S&P 500 declined 3.9% for a year-to-date return of 3.9% including dividends.
Summary:
IBD: Market in correction
BCI: This site is taking a neutral stance on the market as recovery can be even more dramatic than the recent decline once Congress acts in a responsible manner. Corporate earnings continue to impress but political and global issues are overwhelming this positive news. It is inconceivable that our leaders will allow this to continue past August 2nd. This investor is adding NO cash to my current positions as I remain partially protected by the in-the-money strikes recently sold.
Here’s hoping next week’s article has a celebratory tone as we discuss how our leaders finally put party politics aside and did what was best for the folks.
My best to all,
Alan ([email protected])
Premium members:
As a follow-up to yesterday’s post- power has been restored after last nights severe weather and we are currently researching the information for this week’s stock report. We’re back!
Alan and the BCI team
The 3 month returns on the latest etf report are much lower than in previous reports. I’m sure this is related to the current market turpoil. When this happens would it be better to favor individual stocks or maybe just stay on the sidelines until market conditions improve?
All thoughts appreciated.
Barbara
Barbara (#2),
This is my personal opinion…
I am extremely conservative…maybe even more conservative than Alan…if that is possible 🙂 🙂 🙂 In the current market, because of “headline risk’ around every corner, I’m on the sidelines waiting the more clarity. Using Alan’s methodology, we can work around most issues except news…and news can kill you. I’ve paid a lot in “tuition” (aka big losses) learning this lesson…not paying attention to headline risk (and ERs can be put into this category as well).
So, my short term tactic for situations like this is I use the “HIP” plan…”Hands In Pockets”…not on the keyboard. Once the unknowns, good or bad, are known, then we can move forward.
Best,
Barry
Premium Members,
The Weekly Report has been uploaded to the Premium Member website. Look for the report dated 7-29-11 REVA.
Best,
Barry
Does anyone know the percentage of options that are actually exercised? If I were an option buyer I would rather sell the option than exercise.
Thanks.
Paul
Paul,
You’re not alone…very few options are exercised. Here are the statistics for 2010 according to the Options Clearing Council:
Closing sells: 71.6%
Unexercised @ expiration: 20.5%
EXERCISED: 7.9%
It is clear that a huge majority of investors who purchased our call options sold rather than exercised them.
Alan
Premium members:
This month’s list of high dividend yield stocks with LEAPS has been uploaded to your premium site. Look in the “resources/downloads” area for the report titled “High Dividend Stocks with LEAPS August-September”.
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Alan and the BCI team
Alan,
In your dvd set you say that options are rarely exercised prior to expiration Friday but they are American style options that can be exercised at any time. If the strike price is lower than the market price why wouldn’t the option buyer exercise early?
Thanks (the dvds are great).
Brian
I’ve observed that options are rarely exercised prior to expiration. If the strike price is lower than the market price, the call option can be sold for a profit if it was purchased at a lower market price.
Brian and Kerrie,
Options are rarely exercised prior to expiration Friday despite being American style options due to the “time value” component of the option premium. Let’s say we sold a $35 call on a stock trading @ $38 mid-contract. The premium would consist of intrinsic value ($3 in-the-money) + time value, let’s say $0.50 for a total premium of $3.50. If the option holder exercised his right to buy @ $35 he could then sell @ $38 for a credit of $3. If instead, he sold the option for a $3.50 credit, he would capture both the intrinsic + time value. Why lose the $0.50? An exception would be to capture a dividend prior to the ex-dividend date. Here assignment MAY occur if the dividend is greater than the time value of the premium.
Alan
Thanks Alan. This makes sense. One more question please. In your dividend example if the time value is less than the dividend how can we avoid having our shares sold?
Thanks again.
Brian
Brian and Kerrie,
You really need to put yourself in the buyer’s shoes to see why he might not exercise early. Ignoring the “capture the dividend” feature, let’s say I paid $4.50 for a call option. I now control 100 shares of stock for $450. If the stock is well in the money, each dollar the stock rises, my “investment” rises $100.
Let’s suppose we are talking about a $38 stock. I can call the stock, and pony up $3,800, or keep my option, which I bought for $450. Now, the stock rises $1. My $3,800 investment goes to $3,900, an increase of 2.63%. My option would have gone from $450 to $550, an increase of 22.22%.
Class dismissed. Happy trading.
Brian and Kerrie,
There is another reason why an option buyer might exercise early: if he is a short seller getting whacked.
If I sell a stock short I may buy a call option in case the stock heads up, instead of down. Let’s say I borrow shares of XYZ and sell them at $38. I migh buy a $40 call, just in case the stock goes up. Now, I am hoping that it will go to $6, but suppose it goes to $46. Now I already have a paper loss of $8. I finally throw in the towel to close my position. I exercise my call and turn over the shares to the lender. I am now out of the position.
Since the exercise is assigned randomly, the computer will look around for any call that someone sold and still has outstanding. Depending on the current open positions, that assignment just might fall on your account. It’s nothing personal. I just got tired of watching my loss keep getting bigger.
Anyway, that is one of the reasons why an option buyer might call in a stock early.
Brian (#11),
You can buy back the option in advance of the ex-dividend date and assure that you will capture the dividend. However at that point you would be engaging in a different strategy. There is nothing wrong with combining strategies if that’s what works best for you. It’s important to be focused like a laser to maximize returns and that means identifying the strategy you are employing and the goals you are setting. If your decision is covered call writing 1-month options and you happen to lose a dividend in the process, congratulate yourself for achieving your goals and perhaps use the cash to start a second income stream with the same cash in the same contract cycle.
Alan
With the market down 8 days in a row, is this a good time to enter or wait to confirm a bottom? Futures look good this morning. Any thoughts appreciated.
Amy
With 8 down days I have hit the 20% exit criteria on about half my positions. I have not resold calls as I have expected a rally and did not want to limit my upside, I was going to wait for them to rebound some and then sell calls. They have not gone down far enough to hit what I call my “get out price”. What to do? I assume many of you have the same situation, any ideas? I hate just sitting on my hands!
Mark Tooker
I should correct my #16 post above. I bought Sept and Oct puts as insurance on some of these positions and some of them are now ITM. Since I don’t have any further downside risk on them I am sitting on them waiting to see what happens. I sold the puts (at a profit) on the positions that are holding up good.
Mark Tooker
I am waiting two more days. I also closed my short calls. On Thursday or Friday I will resell, roll down or close my long stock positions depending on chart technicals. Friday’s unemployment report will be big. Just my 2 cents.
Fred
Mark and Fred,
The decision as to whether to unwind our positions or use a different exit strategy like rolling down as Fred alluded to depends on one’s risk tolerance. The no-brainer is to buy back the option when it meets the 20%/10% guidelines. Those of us who have experienced volatile markets like we have had recently or even bear markets are more likely to hold on for the short term and new investors will tend to unwind. If you can’t sleep at night unwinding until there is calm in the markets is probably a good idea. None of us like the volatilty we have experienced over the past two weeks and certainly some economic reports have been partially responsible. However, the degree of negative impact has been exacerbated by the egregious behavior of our politicians. These are the folks who are supposed to represent our best interests. Shame on them! The markets WILL recover despite them and we can address their actions at the next election.
(trying hard not to get too political)
Alan
HFC:
The Board of Directors announced today a SPECIAL cash dividend of $1 per share payable on August 22nd to holders of record on August 15th. The stock will also split 2-for-1 on August 31st. The next ER is due on August 5th.
Alan
ROC:
On July 27th announced its 8th consecutive positive earnings report (2nd quarter) as this company has averagred a 21% positive surprise over the past 4 quarters. EPS were up $1.19 compared to a consensus of $0.97. Sales increased by 23%. For the first 6 months in 2011, sales are up over 20%. It stated that demand remains strong and expects margins to remain high and EPS improving. Growth is expected to be 92% for 2011 and another 18% in 2012.
ROC trades at a forward PE of 14 and a price-to-book of 2.5, both stats showing good value. ROE is a solid 16.6%. On our premium watch list for 5 weeks we see an industry segment ranking of “A” and a beta of 1.87.
Alan
Just like 2008? I don’t think so:
I’ve had a few offsite emails from long-term investors expressing how the current market behavior reminds them of 2008. Certainly moves of several hundred points in a day is reminiscent of “the bad ole days” but what is the underlying cause? Is it the same? Listening to the “experts” on TV and radio we see a myriad of opinions ranging from a doom and gloom scenario to “this is a temporary setback and a buying opportunity”. The smartest of these assessments will be determined in the future as we look back. Some will be right, some wrong.
To me, this has a different feel than 2008. The idiocy of the sub-prime debacle was a major driving force to the recession of 2008. Now we are in sluggish recovery but a recovery nonetheless. We have global concerns (see Europe) and unemployment issues that are not improving as quickly as any of us would like. For the most part corporations are reporting favorable earnings with many more positive than negative surprises. With this backdrop I would expect an appreciating market moving upward at a slight angle from the perpendicular, not a rocketship to the moon. We had that until recently. So what has changed? Economic reports? They have been mixed since September of 2010 as I have memorialized in my weekly blog articles.
My feeling is as I stated in comment #19…the world is watching us and no longer feels that we (our political leaders) can manage our affairs. It’s more than embarrassing, it’s a shame. Too many people are getting hurt by the irresponsible behavior of our Congress. The folks are partially responsible as well as we put them in office. We can fix that problem!
The good news is that historically the markets correct on their own despite these negative influences and there’s no reason to believe that it won’t continue to do so. As with the others, my assessment can only be evaluated after the fact. I may feel that the Yankees will make the playoffs this year and give you ten reasons why. In October, we can evaluate that prediction.
Here’s to the playoffs!
Alan
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Alan and the BCI team
I am writing my members of Congress and the Senate to tell them I was all set to write them a campaign contribution check, but their selfish, pigheaded, stupidity crashed the market, and now I can’t afford to send them any money. Oh, well….
I have received dozens of emails over the past few weeks with members expressing their disgust for Congress. They have had it! Many of you have probably seen an email being sent around titled “How to Fix Congress”. It is not the purpose of this site to take a political tone however our representatives are impacting our wallets in a negative way…big time, so I thought I’d share this email with you:
“This is one idea that really should be passed around. Congressional Reform Act of 2011:
1. No Tenure / No Pension. A Congressman collects a salary while in office and receives no pay when they are out of office.
2. Congress (past, present &future) participates in Social Security. All funds in the Congressional retirement fund move to the Social Security system immediately. All future funds flow into the Social Security system, and Congress participates with the American people. It may not be used for any other purpose.
3. Congress can purchase their own retirement plan, just as all Americans do.
4. Congress will no longer vote themselves a pay raise. Congressional pay will rise by the lower of CPI or 3%.
5. Congress loses their current health care system and participates in the same health care system as the American people.
6. Congress must equally abide by all laws they impose on the American people.
7. All contracts with past and present Congressmen are void effective 1/1/12. The American people did not make this contract with Congressmen. Congressmen made all these contracts for themselves. Serving in Congress is an honor, not a career. The Founding Fathers envisioned citizen legislators, so ours should serve their term(s), then go home and back to work”.
(Me now): By taking away Congress’ candy and video games perhaps they will learn how to behave properly.
Alan
Pretty good, Alan.
One of my thoughts is amending the constitution to allow only one Senator from each state, and doubling the population per House member. That cuts the size of Congress in half and eliminates 1,500 support staff. It’s a start.
Just when it looked like maybe the worst was over the downgrade came last night. What to do? It sure will be another interesting week. The worst part is having the whole weekend to think about it.
Mark Tooker
Perhaps Congress can save some time. When they hold those hearing about why the credit agencies didn’t sound the warning about the fincancial disaster the banks were getting into in 2008 and 2009, they can also ask how the same credit agencies can possibly consider the US financial condition is anything but perfect.
Can you spell hypocritical?
So, again, if con is the opposite of pro, is Congress the opposite of Progress?
If you choke a smurf, does he turn the same color as Boehner defending tax cuts for millionaires and benefit cuts for Social Security recipients?
I’ve spoken to a few Wall Street insiders who feel that the recent downgrade will not have a major negative impact on the market. They regard it as a “slap on the wrist” almost a warning to get our act together. That is why (they hypothesized) only one of the three agencies acted on a downgrade.
Premium members: As my team works on this week’s report, we anticipate most stocks to end in the “pink” cells as market forces are impacting even the best performers. We are also working on a second report, an “Emergency Special Report” discussing management tactics and strategies when market forces are negatively impacting share value. As with the regular weekly report, we will send out an email to our members and post on the blog when this “extra premium report” is available.
Alan
That’s an interesting article on margin accounts, just a pity there are hardly any questions related to it!
But I have 3 things that I am not quite sure of(in case I ever were to use margin loans), and they are:-
-First I have read that if I had a margin loan, that I should always have a minimum of 20% of my portfolio in my account(as margin) to cover a margin call. But does this seem right?, and if so then would I even need an amount of 20% or would a lesser amount do instead?
– I have also read that in order to use margin loans, I need to have a high ‘taxable income’, and be a low ‘marginal tax-payer’.
Can you tell me if this is true?, – and if so then is there any way I could use a margin loan, as I don’t have a high taxable income?
– Also how would we know that we are so experienced at this strategy, to be able to use them?
If I ever get really good at this strategy then I may possibly use them, even though I think they are pretty risky, and would rather go for any other type of loan if needed first! thanks