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.
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.
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.
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).
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).
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)