MarginI was once asked ‘Is trading options dangerous?’
My response is this … Is a sharp knife dangerous in the hands of a 2 year old?
Of course it is!
Any responsible parent wouldn’t give a 2 year old access to a sharp knife as they lack the skill set to handle such a tool. However, that doesn’t stop a responsible adult from using one.
So logically you then must ask is there a danger to an adult using a sharp knife? Yes! In fact just the other night in a lapse of concentration I cut myself with a very sharp knife while trying to slice myself a piece of bread. So a knife is useful for cutting bread. In the wrong hands or in a lapse of concentration it can be a very dangerous instrument. (Or perhaps my knife skill set is that of a 2 year old.)
It’s the same with options trading. If you don’t know what you are doing you can get yourself into trouble. However, knowing how to use it to your advantage is a very useful skill.
Similarly, margin has been called a double edged sword. It can be a great tool to leverage to make a profit but if not handled correctly can create greater loss than you were expecting.
So knowledge is paramount! Ignorance is expensive!
THE PROS & CONS OF MARGIN
Margin is a loan from the broker which allows you to buy more stock or trade more option contracts than you have cash.
In brief the pros for using margin are:
- It can give you leverage and potentially greater profits that you otherwise would not have.
The cons for using margin:
- It can amplify losses
- It must be handled with care
- It is not generally allowed to be utilised in a Self Managed Super Fund which can restrict some traders in the strategies they’d like to utilise through a Self Managed Super Fund. (On this point traders should seek specialist advice from a qualified accountant in Self Managed Super Funds.)
Margin use differs from stock trading and options trading. We’ll first address it as it applies to stock trading and then look at its application to options.
As a general comment the big problem with margin is the emotion of greed.
I remember speaking with a financial planner who had that problem after the 2009 crash. He had bought shares on margin, the market had crashed, and he was now $90,000 poorer for it. It was money he didn’t have and now was paying it off.
Here was someone in the know in their profession and greed had kicked in. Additionally, there were no protection measures in place to protect the portfolio.
I also recently met a man who also went through a similar situation. He would buy the stock using margin to the sum of a $1 million and write calls over the stock to create some cash flow. He also had protective puts on the portfolio. In some cases every time the stock went up by 10c he’d in some cases he’d be making $10,000. He said it was amazing. He did the exercise twice successfully with his protective puts in place.
On the third occasion he decided to place the trade without protective put positions in place. It again was 2009. The market crashed and he lost his borrowed money. To his credit he admitted he knew where he went wrong in his trade. He didn’t put in the protection. He blamed his gambling nature and when I met him 5 years later, and heard this tale he said he had never traded since and was trying to rebuild his wealth. For this man it was more than a loss of capital. It was a loss of confidence.
Lose your confidence and you are doomed! Stray from your protective measures at your own peril. It’s a too common tale where a trader makes a few winning trades, the greed sets in and they begin to take on risks they didn’t before. Margin mixed with greed can be a dangerous combination.
For many traders it’s an expensive lesson. Balanced psychology is the key.
HOW MARGIN WORKS?
When setting up an account that involves margin, the broker will require a trader’s signature. Some will require a minimum $2,000 in the account. Brokers will allow up to 50% borrowings of the stock purchase price or 25% on options contracts in your account. Terms and conditions vary and change depending on the stock, broking firms, and regulators. It is absolute key a trader reads the fine print and understands their obligations.
Additionally, I have been in trades and received a notice that the margin requirements for a particular stock has been increased in an instant without pre-warning. The broker can decide that a stock is now riskier to trade and suddenly change the requirements to hold positions over this stock. They also can decide a particular strategy is riskier than another and change margin requirements on the position.
They won’t cover every stock and as mentioned can change the lending criteria on a particular security.
Think of a broker as a bank. Banks won’t take risks, and they ensure one way or another that they’ll get paid back. A broker is similar. They want to ensure any lending will be paid back and can change the rules on a whim.
I only commit 50% of my trading account to the market at any one time to protect myself from these kinds of scenarios. This allows plenty of flexibility for changing conditions. Additionally, the requirements a broker will have to hold back on margin will change as the market fluctuates. If trades are going against you, depending on the trade, a broker will hold more back as compared to if they are going in your favour.
There are some general guidelines with margin …
The loan is generally indefinite. You can have it as long as you want, as long as you meet the requirements of the agreement.
For some accounts in trusts a broker may want to see 2 years of financials to ensure the entity can meet its obligations. Since September 11 and the passing of the Patriot Act, identity when setting up accounts especially in dealing with US markets and currency has required brokers to really ‘know their client’ and be able to report when required by government authorities.
Like a bank loan when a house is sold, the bank is paid first. So it is with a broker when selling stock. A stock is sold and the broker’s loan is paid fully with the remainder going to the trader. The securities are collateral for the loan. If they drop in value more lending is required to hold onto that security. (This will be discussed further in Margin Calls & How They Work.)
Naturally there is interest payable on the loan. With options the position is generally a short term one.
The way it works is that interest is charged after an account’s initial capital is used. On an account of $15,000, $30,000 is available to trade or buy stock with. This is because the initial 50% of $15,000 is put up by the trader giving $30,000 worth of buying power. If $5,000 worth of capital is used to purchase stock, your initial cash covers the position so margin is not accessed or used. $10,000 remains for you to purchase stock with. When you exceed the initial $15,000 then interest is charged at the broker’s rate.
Traders who use margin must read the terms, conditions and understand any implications the broker outlines in their agreements. If needed ask the broker lots of questions before signing.
MARGIN CALLS & HOW THEY WORK
What you have to be aware of are margin calls. A broker will have a minimum balance required within the account that must be maintained before they will send a notice of a margin call.
Think of the security as having a value. Like a bank they will offer a certain percentage of the underlying asset. So if a house is valued at $500,000 the bank may require a 10% deposit offering a 90% loan to variable ratio.
With securities the fluctuation in the value of the portfolio changes with the movements of the market. The broker will have a requirement called a maintenance margin where a certain value percentage of the underlying asset must be maintained as a condition of the loan. If the value of the account breaches this percentage the broker will issue a margin call.
When this occurs either a trader will be required to deposit more funds or need to close out trades to maintain the required balance.
If a trader fails to maintain this balance a broker may close out trades and sell security to ensure the cash requirements are met. This can include closing out winning trades.
Margin requirements are determined not only by the broker but also the government regulators. When dealing with US options it is the Federal Reserve Board. In Australia the ASX Clear works with brokers to ensure margin requirements are maintained. The Federal Reserve Board insists a maintenance margin of at least 25% is maintained and sets minimum initial margin at 50%. The maintenance margin can range between 25% – 40%.
So if you had $15,000 in your account and you bought $30,000 of stock, let’s say the value of the account fell to $18,000. $18,000 (value of account) – $15,000 (of borrowed funds) = $3,000. If you had a maintenance requirement of 25% you would need
performance, market conditions, broker and regulatory requirements.
In my personal trading I have many measures in place to limit loss which I’ll show later.
In some strategies the maximum loss can actually be calculated. So you can measure the worst case scenario and also the best case situation of making profit even before taking the trade. And with options you know you will generally get a defined result within a certain time frame.
In addition to margin calls the margin requirements can be a restriction on the amount of trades you can take at any one time. I’ve worked with a particular reverse spread ratio trade where some of the sold positions are not covered by bought positions. The broker’s margin requirements changed, and did not allow me the flexibility to diversify because of the large reserves they required. I use diversification to ensure my portfolio is balanced, so the more trades I can get the better protection it offers me.
I had to find a solution. My mentor showed me one. By restricting the loss I could manage the margin far better. A slight adjustment of the strategy and the margins were back under control allowing for greater trades and diversification.
What a trader must realise is there is one constant with trading – change! There are changing markets, stocks and companies and requirements of the brokers.
Margin allows you leverage but if not maintained and controlled amplified losses are possible especially if trading stock or naked options with no protective measures.
Margin may not be for everyone. Ultimately it comes down to risk profile, skill of the trader and their ability to defend when things don’t go their way.
Reference: http://www.investopedia.com