Your recent article, Naked Puts Are a Dangerous Game, started with a promise to "explain why leverage can be very risky in options investing." Unfortunately, you went on to demonstrate your bias against put-writing, one you share with other
writers. How about an article that really helps us manage margin? How much is enough? Or too much? What are the yardsticks we should use and how can we use margin to help optimize our returns? Consider this situation: A stock portfolio, let's say $1 million, is fully invested in stocks. The investor is basically bullish (probably wouldn't be fully invested if he wasn't). He knows he could buy another $1 million of stock on margin and incur margin interest. If his bullish bet is right, he will be well rewarded. If he is wrong, he gets stung badly -- especially if he really used up his entire margin, because he would be unable to carry all the stock and would be forced to sell. His real challenge is to use only an appropriate amount of the margin. But how much is appropriate? -- Don Fuerst
At the risk (risk, get it?) of sounding like "other
writers," I'll chime in with this: Trading on margin ain't for everyone. If it were, we'd be born with preapproved credit limits stamped on our silky-soft bottoms.
Buying on margin simply means borrowing a portion of your total investment from your broker. Only a portion of the money you've staked is your own. The rest is what's often thought of as "leverage."
Leverage, technically, is any process that increases exposure to a source of risk. Purchasing securities with borrowed funds is one method of leveraging a portfolio. Concentrating exposure in a limited number of asset classes is another approach. Derivative instruments, such as options and futures, are also very efficient levers because they provide exposure to underlying assets for relatively little capital. Derivatives, for that same reason, can be combined with leveraged investments to curtail overall risk.
Perhaps an example will illustrate the concept of leverage. Let's imagine your portfolio is now invested as follows:
If you want to aggressively capitalize on a forecast of rising stock prices, at the expense of diversification, you could increase the allocation to the equity asset class. The new allocation could then become:
There's one example of leverage: compounding risk into only one asset class. Bottom line? Own just stocks and you're automatically leveraged.
You could increase your stock exposure even further with margin. If you collateralized your stock to finance additional stock purchases, the portfolio allocation could become:
You've now got exposure to stocks equal to 200% of your total capital. Stock-market risk thus has been greatly magnified.
So, borrowing itself is not leverage; it's simply one way that leverage can be achieved. Leverage can also be obtained by entering into certain derivative transactions.
The query in the article, Naked Puts Are a Dangerous Game, dealt with short puts. Any option transaction bestows "delta" upon an investor's portfolio. (See
Deconstructing Delta.) Delta represents exposure, short or long, to the underlying asset.
Owning one put, for example, with a delta of minus 0.35 functionally provides the same price exposure as being short 35 shares of the underlying stock
(-0.35/share x 100 shares) x (+1) contract. Conversely, writing the put is tantamount to buying 35 shares
(minus the 0.35/share x 100 shares) x (-1) contract. Short puts increase bullishness (as do long calls) while long puts (and short calls) reduce long market exposure.
Now, Don, I know you asked me to consider your example of margining a $1 million stock portfolio, but there are commoners in the room. To help them as well, let's start with $20,000 of fully paid stock instead.
initial margin requirement at 50%. The
Gang says you gotta "own" at least half the margin account's initial value.
With your $20,000 fully paid and marginable stock position, you could buy another $20,000 worth of stock "on the tick," making your account long $40,000 in stock. You now have an equity stake equal to half the account's market value.
If your broker's equity maintenance requirement is 35%, as long as your securities' value remains above $30,769 (and as long as your debt to the broker doesn't increase), you'll avoid the much-dreaded margin call. If your equity slips under the minimum equity level, however, you'll have to fork over more cash, deposit additional securities or sell some stocks to raise your equity stake.
Obviously, maxing out your borrowing power makes you more vulnerable to a maintenance call. In your case, the $20,000 amount you borrowed to purchase additional stock will remain an outstanding loan, accruing interest. Whether your stocks go up or down, you'll still owe that $20,000 plus interest. The accrual of interest alone reduces your equity, especially in a high interest rate environment. For this reason alone, a rate of return realized on your leveraged investments that's below the margin interest rate turns your account into a losing proposition.
If your portfolio value drops by, say, $6,000, the loss comes out of your equity. In that case, your equity sinks to 41% from 50%. So, with a 35% equity requirement, you'd still be safe from a maintenance call. Lose another $6,000 in market value, though, and your $8,000 equity puts you under the maintenance level. Then, you'll get a call to deposit either $1,800 cash or $2,769 in marginable securities. If you can't meet the call, your broker's entitled to sell off $5,143 of your portfolio's stock.
In the above example, your portfolio lost only 30%, but the drop landed you squarely in margin-call territory. Borrow less and you'll be less likely to end up in such unpleasant climes. Start again with $20,000 of fully paid securities. Taking a loan of only $5,000 to finance additional stock purchases means your portfolio's market value would have to drop to $7,692 -- a 69% hit -- before you'd get called.
Ponder the likelihood of such declines in your portfolio's value. The single worst one-day loss in recent times, in October 1987, was a 23% dip in the
Dow Jones Industrial Average
and a 20% drop in the
Pacific Exchange Technology Index
, or PSE. To be sure, these one-day plummets were statistical outliers.
Surviving this leads us to consider standard deviation, the measure of how much a portfolio's or an index's returns typically vary. Currently, for example, the average daily price change in PSE is 0.28%; PSE's annual standard deviation is 1.87%. Simply put, this means that about two-thirds of the time, PSE's daily returns fall somewhere between 2.15% and minus 1.59% (one standard deviation). A portfolio studded with tech issues is twice as volatile as PSE, 95% of the time, and it might be expected to change somewhere between 8.60% and minus 6.36% on any given day. Suffice to say that it won't take many off-6% days before
Uncle Vito shows up looking for more moolah.
Yahoo! Finance provides historical index prices that can be used for statistical comparison with your portfolio.
A reduction in borrowing insulates a portfolio from downside volatility. Adding an options hedge can also reduce risk exposure while still preserving the leveraged profit potential of a fully margined account.
Suppose your $40,000-margined stock portfolio correlates strongly to the Generic Market Index (XYZ) but is twice as volatile. If XYZ is now at 750, the total contract value of an XYZ index option is nominally $75,000 (750 index points x $100). Buying an index put to hedge the portfolio at first looks like overkill, but since the portfolio is twice as volatile as the index, it's really a good fit.
If you're looking for "disaster" insurance, pick a strike price two standard deviations out. For example, if XYZ's standard deviation is 2%, then a strike 30 points below the current market (750 x 4% = 30), or 720, makes sense. You'll need to make an adjustment for the 720 put's delta, though, to give you adequate coverage. If the option's delta is minus 0.35, you're actually going to need to buy three contracts to fully insure the portfolio.
If the portfolio sinks precipitously, and the correlation to the index remains constant, you've now got an appreciating asset, the puts, that can be used to offset the margined losses. (Using call sales to finance put premiums can reduce the costs of hedging, but that's a topic best addressed at a later date.)
In the meantime, Don, don't mistake me for those other
Brad Zigler is managing director, Options Marketing, Research & Education of the Pacific Exchange. Send email to:
Dr. Option. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs, which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone. The Pacific Exchange, as a matter of policy, disclaims any responsibility for any private publication or speech by any of its members or staff. The views expressed herein are those of the author and do not necessarily reflect the views of the Pacific Exchange or the author's colleagues at the Pacific Exchange.
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