Freedom 48 Investment Toolkit: Margin Account And Option Basics

Margin Account And Options Fundamental
 

A while ago, in my emergency fund post, I used the buying power in my margin account as a way to access funds in case I need it for an emergency. Even though it is a viable and flexible method to get access to cash in a hurry, it’s not my true intent when I opened a margin account at my investment brokerage. The real reasons that I got a margin account were to take advantage of investment opportunities even if I don’t have money to invest at that moment and to incorporate an additional investment tool into my investment strategy – trading options. In this post, I will cover the basic fundamentals of a margin account and options. In a follow-up post, I’ll walk you through the different options strategies that I use to improve my investment returns.

Margin Account

A margin account is an investment account at an investment brokerage that allows you, the investor to borrow money from the investment brokerage to invest. The amount that you can borrow depends on the total value of your account and the type of assets that you have in that account. The riskier the assets that you own, the lower the amount that you’ll be able to borrow (the brokerage wants to protect its loans to you). You can borrow up to 50% of the values of the assets that you have in your account. When you borrow money, you’ll be charged interest on a daily basis and will have to pay the interest portion of the loan at the end of every month.

Margin Call

A margin is an amount that the brokerage is willing to lend you based on your assets. For example, if your account has a total value of $100,000 and you have a 50% margin, it means that you are allowed to borrow up to $50,000 from the brokerage. If the total value of the assets in your account drops, your ability to borrow will decrease and the opposite can be said if the value of your assets increases. So when do you get a margin call? Let’s assume that you borrowed $30,000 of the $50,000 that’s available to you. As long as you maintain a 2:1 ratio of total asset value to loan value, you won’t get a margin call. If we work backward, twice the amount of $30,000 is $60,000. Hence, you’ll get a margin call if the total value your account dips below $60,000. You normally have one to three business days to deposit money into your account to bring the ratio back to the 2:1 asset to loan ratio if your account value dips below that ratio. If you can’t make the deposit, the brokerage will sell your assets and take the proceed of the sale to repay part of the loan (to bring the ratio down to 2:1). This is the risky part of using a margin account so always leave yourself some room for error.

Call Options

A purchaser of a call option essentially purchase the right, but not the obligation to buy an asset from the writer at a predetermined price (strike price) within a limited time frame (expiry date). The purchaser would have to pay the writer a premium (a fee) to have that right. You buy a call option if you think the price of an asset will increase beyond the strike price plus the premium. This is how you make money without owning the asset and only make a fraction of the investment.

Covered Call Options

A covered call option is a situation where the writer of the option owns the underlying asset and believes that within the expiry date of the contract, the price of the asset won’t increase to more than the strike price. By selling a covered call option, the writer can pocket the premium and make money without selling the asset. For example, I own 100 shares of the Bank of Montreal common stocks and I don’t think the stock price will go any higher than $105 per share within a year (the price of the stock is about $96 at the time of this writing). Hence, I sell one covered call contract (one contract = 100 shares) for the Bank of Montreal stock with a strike price of $105 and expire within a year. I can collect about $150 ($1.50 of premium per share). I will make money if either the stock price never reached $105 within a year or the purchaser elect not to exercise the option to buy the stock before the expiry date (even if the stock price is higher than 105).

Put Options

A purchaser of a put option essentially purchase the right, but not the obligation to sell an asset to the writer at a predetermined price (strike price) within a limited time frame (expiry date). The purchaser would have to pay the writer a premium (a fee) to have that right. You buy a put option if you think the price of an asset will decrease beyond the strike price minus the premium. This is to limit your losses to the amount of the premium that you pay over a period if you buy a very risky asset or you are betting that the underlying asset will decrease in value and you want to reap the benefit when it happens.

Naked Put Options

A naked put option is a situation where the writer of the option do not own the underlying asset and believes that within the expiry date of the contract, the price of the asset may not decline to more than the strike price. By selling a naked put option, the writer can pocket the premium and make money without purchasing the asset (or want to buy the asset at a price that’s lower than the current price). For example, I don’t own shares of Telus common stocks and I want to buy it at a lower price than $43 per share within a year (the price of the stock is about $43 at the time of this writing). Hence, I sell two naked put contracts for the Telus common stock with a strike price of $38 with an expiry date within a year. I can collect about $300 ($1.50 of premium per share). I will make money if either the stock price never reached $38 within a year or the purchaser elect not to exercise the option to sell the stock before the expiry date (even if the stock price is lower than $38). In addition, if the purchaser does exercise the option, I’ll get to buy the stock at a lowered price (around $36.50 instead of $43 per share).

Requirements

To open a margin account, buy put and call options, and write covered call options, there is no experience or financial requirements. However, if you would like to write naked put options, there are financial and options trading experience requirements needed. Depending on the brokerage that you sign up with, the financial and trading experience varies. For my broker, I require a minimum of $25,000 of total asset value in my margin account and at least one year of options trading experience in order to write naked put options.

My two cents

Every investment strategy involves a certain level of risk. This strategy is not suitable for novice investors if you are just starting to learn how to invest. However, this can be served as a guide for novice investors once you’ve gained enough experience or for the seasoned investor that wants to add another investment tool to either stabilize the volatility of his/her portfolio or improve the overall return on his/her investment portfolio. Let me end this post by quoting my favourite investor, Mr. Warren Buffett, “The more you learn, the more you’ll earn.”

 

Remember, only use the strategies that you understand and are comfortable with the level of risk for the strategies.

 

(Update: added the link to the Freedom 48 Investment Toolkit: Using Options To Improve Investment Returns post)

Leo T. Ly, Canadian Personal Finance Blogger/Enthusiast and a Realtor Living in the Markam, Ontario, CanadaAbout Leo
I am a Canadian personal finance blogger/enthusiast and a Realtor living in Markham, Ontario, Canada. I built a net worth of a million dollars over a ten year period. I did it by being a disciplined saver, taking advantage of income tax rules and borrowing money to invest rather than for consumption. I am often excited to take advantage of free money from employers and governments in addition to building more passive income sources. After accumulating my first million dollars, I am now embarking on a second journey towards achieving financial independence. On this journey, I will strive to increase my net worth to two million dollars and retire by the age of 48 - Freedom 48. Come along and follow my journey.



There are 7 comments on this post.

  1. Great basic guide. My portfolio is not at a level where I can start buying individual stocks yet. I will bookmark this and will revisit this post when my portfolio is large enough. Is this strategy time tested?

    1. @Raphael, I’ve been using options strategies for about eight years now. I am not sure how long is your definition of time-tested, but I think eight years is a pretty good gauge.

    1. @The Kidd, you can buy options without any restriction in your RRSP and TFSA accounts. In terms of restrictions, you may not be able to write naked put options in those accounts. Every brokerage’s rule is a bit different, give your brokerage a call to find out all the restrictions.

  2. Leo, on options, I see that you trade covered calls out of the money as well as naked puts. Have you ever traded ‘deep in the money’ with ‘ long covered calls’ LEAPS?

    Telus currently in the $44 range, with a 12 month target of $46 by several analysts

    example: The Telus stock mentioned above, in addition to the ‘naked put’, on the basis that you own 1000 shares, then selling (10 contracts) covered calls long call out 12 or 24 months ‘deep in the money’, lets say $4 – $5 below the current stock price.

    When doing this generally a few days before the first ex-dividend date (5 – 8th June) for the reason when the stock goes ex-dividend it generally drops a few pennies. Always making sure that the dividend date 9 june 2017 is before the current month option expiry, using 16 June 2017 as an example

    The benefits

    1. Hedges against a price drop, even though there is little to zero premium in the difference between the option strike price and the current stock price of ~$44
    2. Allows you to collect several dividends
    3. The $4 to $5 difference is used to buy 100 shares more stock, then sell a covered call with that 100 shares (1 contract) at the money long Jan 2018 or 2019 & pick up another $3 to $5/share premium

    The net result is that its possible to increase the divided income by 50% from 4% to close to 6%

    This could be done with several other blue chips, BCE, all the Canadian banks because they have different ex-dividend dates. In this case, Buying the stock a few days before ex-dividend date, selling a covered call current for the current month the stock goes ex-dividend, selling that covered call just in the money to make sure that you always get called & after you qualified for the dividend. A 4% annual dividend is picked up in a few days. When called on the option, on to the next stock & repeat, or do the long covered call deep in the money exampled above.

    Does any of that make sense, will it work?

    Research is needed on those stocks that go ex-dividend before option expiry date.

    1. @ John, there are many strategies when it comes to trading options. Some people use it to earn a bit more dividends (like your strategy), while other use it to limit their downside risk (like buying put options). For me, I have two strategies, either to make more money when my options are exercised or free money when it’s expired.

      For example, I bought 100 shares of Chipotle Mexican Grill CMG @ $430/share around October 2016. I sold one covered call contract with a strike price of $600 expiring at January 2018, right after my purchase. If my option is exercised, then I make about $17,000 or a 39% in just a little over a one-year period. I am more than happy to sell. On the other hand, if the put option is not exercised, then I get to keep about $1,600 in premium, about 4%. It’s just like I am getting a free dividend.

      For in the money covered call options, I am not a big fan of that as I don’t make a lot of money when the option is exercised. When I write a covered all option, my goal is to make at least 15% (dividend + premium + capital gain) from that investment if the option is exercised.

      Thanks for dropping by John, I love these questions and I hope that my insights can help you improve your own investments.

  3. what interest rate on the margin account is your broker charging you?

    Would you mind commenting on which broker it is that you use & why?

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