One way to increase leverage in covered call writing is to buy the stock on margin, which is a loan from your broker. The broker will lend you the allowable stock margin and then the proceeds from the call write are applied, thereby reducing the amount of investment that you must make. The maximum margin allowable in a stock buy under the current Regulation-T rules is 100%, meaning that you must put up at least 50% of the stock price. The 50% margin release is calculated on the lower of the:
- Stock price, or
- Call’s strike price if OTM
This requirement keeps traders from writing deeply in-the-money calls without having to put up any money at all. The broker may choose to extend less than 50% margin, or even none. Remember that margin is a loan and you must pay interest on the cash amount used; currently about 8% per annum as I write this (about 0.75% a month). This cost of borrowed money is known as the cost of carry for the margin position. Margin is even more advantageous to use in covered writing, because the call premium helps to meet the initial margin requirement.
Let’s revisit our earlier CSCO example – assuming we buy 500 shares of the stock at $20.00 ($10,000) instead of $19.75, but write the October 20 Call, which is six months out, for a premium of $4.00 ($2,000 in total premium). This reduces the cost per share to $16 and the total trade debit to $8,000. We will assume no trading costs, no dividends received, and an annual margin interest rate of 9%. Since the stock price and strike price are the same, margin will be calculated on the $20 price.
|Margin Transaction in CSCO (Reg.-T Margin)|
|Cash Required||4,000.00||$20 – $4.00 x 50%|
|Broker’s Loan||4,000.00||8,000 x 50%|
|Margin Interest – 6 mo.||180.00||9% p.a. x $4,000 x 0.5 years|
|Cash Profit if Called||1,820.00||$2,000 – $180 interest|
|Raw Return if Called||45.5%||$1,820 profit ÷ $4,000 investment|
|Annualized Return if Called||91.0%||45.5% x 2 (6-month holding period)|
Margin Results. We only had to put up $4,000 of our money to put on a trade in $10,000 worth of CSCO stock (500 shares x $20 share price). Had we bought the $10,000 of stock without writing calls, we would have had to put up $5,000 (50%) of the stock’s cost. Thus writing the calls saved us $1,000 in cash outlay.
The 45.5% return is calculated on the $4,000 of our cash put up in order to illustrate the level of return possible. Use of margin in this example increased the return to 45.5% on our money for the six months in the trade: nearly double. But note that this calculation ignores the fact that the trader was at risk for the money borrowed on margin. Even though our margin release was 50%, we got more leverage than that due to the premium brought in, which helped meet the margin requirement.
Results without margin. Had the trader not used margin in this example, the return would have been 25% (4.16% per month average); the $2,000 in premium received divided by the $8,000 net stock cost – or think of it as the $4 premium divided by the $16 net stock price. Still, not too shabby.
The following table compares the two alternatives: using full margin or cash only:
|Margin Transaction in CSCO:
Comparison of Cash vs. Margin (Reg.-T)
|Margin Interest – 9% for 6 mo.||160.00||.00|
|Cash Profit if Called||1,820.00||$2,000.00|
|Raw Return if Called||45.5%||25%|
|Annualized Return if Called||91.0%||50%|
Margin can more than double returns on ITM writes, because the larger premium (even though it does not reduce the margin requirement, which still will be 50% of the stock price) nonetheless helps meet the margin requirement. A trader with $8,000 in his account could have run twice the number of shares (1,000 = $16,000) in the trade above. Remember, though, you are at risk for the amount borrowed from the broker. Should the stock collapse, for example, that margin loan still has to be repaid. Thus computing the return only on the cash you put up – while perhaps correct in accounting terms – ignores the margin writer’s total risk.
The use of full margin can double returns. However, using full margin also doubles the risk. The fact that you can run the trade with broker money does not mean that you should. Yet margin is not a bad thing: the key is not to over-extend oneself. When using margin, your trading must be highly disciplined. Not being able to monitor trades is a very negative consideration for employing margin. My feeling is that covered call margin is only suitable, and smart, when you are sticking with large, extremely stable companies in strong industries – and not facing a major news event before expiration. Using margin on risky, volatile stocks is not for the faint of heart, or faint of pocket-book.
If a position entered with margin is impaired, the broker will require you to put additional cash into the account. If you don’t get the cash or additional marginable securities to the broker immediately, the broker can sell securities in the account to generate cash – equity – to bring you towards maintenance.
Obviously, your net worth and similar factors make a difference in how the broker treats you. Under almost all margin agreements, your broker might not even be required to issue a margin call before selling you out. Most agreements allow the broker discretion whether to wait on you, or even give you a chance to meet a call. And if securities are sold out of your account, you have no control over which ones are sold.
Under FINRA (Financial Industry Regulatory Authority, formerly the NASD) rules, you must maintain account equity equal to at least 25% of the value of the marketable securities in your account. This is known as maintenance margin. But 25% is a minimum only and your broker (or its clearing house, more to the point) may require a higher maintenance percentage.
MAINTENANCE EXAMPLE: You put $10.000 in cash into your account and borrow $10,000 from your broker to buy stock for a total of $20,000. Your equity at this point is $10,000 ($20,000 stock value – $10,000 margin loan). But suppose the stock’s value falls to $12,000? Now your equity is down to only $2,000 ($12,000 value – $10,000 loan), yet the 25% maintenance requirement is $3,000 (12,000 x .25) meaning you will get a margin call to put in $1,000. But if your broker had a 40% maintenance requirement, the equity needed would be $4,800, and the margin call would be $2,800.
The existing Regulation-T margin system dictates that margin is utilized and calculated by each strategy deployed. Currently, the maximum amount of initial margin on a straight stock purchase is 50%. Thus you could buy IBM on margin at $91.25 by putting up only $45.625 per share. Your account might for example include five different types of trades, such as long stock, a covered call, a debit spread, a long condor and so on. The Reg.-T margin requirement for each of these strategies is uniquely different and set according to rigid formulas, and the risk profile of any one type of trade strategy does not affect or offset any other held in the same account.
Thus in a very simple case, if you purchased three different stocks on margin (ex: DELL at $25, IBM at $91.25 and GE and $32) and IBM was dropping but the other two stocks were up, you might at some point get a margin call (be required to put more equity into your account) on the IBM trade. The fact that the other two stocks were up might not make enough difference to avoid a margin call.
For that matter, Reg.-T margin requires that you put up 50% of the stock cost (the net amount at risk) even if you have purchased a protective put that makes a loss impossible! For example, if you buy a stock at $20, write the 20 Call and buy the 20 Put for the same expiration month as the call – a trade known variously as a collar or hedge wrapper – there likely is little profit in the trade, but there literally is no risk to you or your broker in the trade, even if the stock goes to zero. The reason is that you can sell the stock at $20 in every circumstance. Yet under Reg.-T rules you would be required to put up 50% of the full stock price (plus put cost, less call premium). Does this make a lot of sense in a truly riskless trade?
On April 2, 2007, a new set of margin rules was approved by the SEC for a test program that sets margin collateral requirements based on the potential loss for an entire portfolio of securities, instead of by the risk of loss of each individual trade without regard to other trades in the same account. These new rules, called portfolio margining (because margin will be based on the account’s overall risk profile), will dramatically reduce the amount of money that qualifying investors must put up to execute many options trading strategies. Trades such as long stock + protective put and covered call + protective put will particularly benefit from the new rules because of the degree of price protection offered by the long put.
The new portfolio margin requirements are equal to the maximum potential loss on a portfolio based on an increase or decline of as much as 15% in the value of each investment held in the same account. Unlike the current Reg.-T rules, the new rules will have the effect of aligning the amount of margin money required to be held in a customer’s account with the risk of the portfolio as a whole, calculated through simulating market moves up and down, and accounting for offsets between and among all products held in the account that are highly correlated. For example, SPX options on the S&P 500 Index can be offset against SPY options on the S&P 500 Depositary Receipts but not against stock.
The term “portfolio” in this context refers to securities in the same account; securities in one account will have no effect on margin in another. Essentially, “healthy” positions will offset positions that are moving adversely for the trader. Thus even a trade or two in trouble may not provoke a margin call if other positions in the portfolio are healthy enough to offset the impaired ones.
The operation of portfolio margining will not be simple, and could only occur in a computerized environment where software can continuously make the required computations. The new margin requirement is computed by “stress testing” an account at ten equidistant intervals (valuation points) representing assumed market moves, both up and down, in the current value of the underlying security or index.
Gains and losses at each valuation point are netted, and the greatest net loss among the valuation points will be the margin requirement for that portfolio. For stocks, stock options, narrow-based indices and security futures products, PM requires assumed up/down moves of ±15% as the end points.
Portfolio Margin and Covered Calls
For some strategies, such as long stock with a protective put or a covered call, the difference could be huge, since the new margin calculation will account for the fact that the risk of one position (long stock) is offset by the other (long put). However, the new rules will significantly lower the margin required on covered call positions, as well, at least in circumstances.
While I am no advocate of offering every trader 1929-style leverage for speculation, the margin requirements should be aligned with the position’s true risk. Portfolio margin simply applies the concept of risk alignment across the entire portfolio.
The following covered call example provided by the CBOE illustrates the scale of difference in the Reg.-T and portfolio margin rules:
Covered Call Write
|Cost||Reg.-T Margin*||Portfolio Margin|
|Buy 500 shares IBM||– 91.25||– 45,625.00||21,422.50||5,504.00|
|Sell 5 IBM $95 Calls||2.78||1,390.00|
|Net Cost||– 88.47||– 44,235.00|
|Reg.-T Initial Margin:
The initial margin requirement under Reg.-T rules is calculated on half the gross stock price less the credit received from writing the calls ($45,625 ÷ 2) – $1,390.00 = $21,422.50.
In the covered call example above, the trader must put up $21,422.50 in cash under Reg.-T margin rules, but only $5,504.00 under the portfolio margin rules, to buy more than $45,000 of stock – just slightly more than 25% of the amount needed under the existing Reg. T rules! The addition of a protective put will lower the portfolio margin requirement even more drastically.
Putting up 12% or less of the stock’s cost for a covered call trade may be enticing, and the writer can indeed make a killing on the 88% of the position bought with the broker’s money. However, don’t forget that interest at approximately 8% per annum must be paid on the borrowed funds. Worse, if the trade goes wrong the writer will take the loss on all the shares, including the 88% bought with margin cash. Suppose that a market crash took an entire portfolio down: there would be no “healthy” positions to offset the stocks selling off, with potentially disastrous results for the account. The use of portfolio margin should therefore be kept to levels that present manageable risk.
Under CBOE rules in force as this is written, portfolio margin privileges may be extended only to accounts that have a minimum liquidation value of $100,000. Brokers may impose other financial or suitability requirements, as well. Be very careful when using margin. It is only advocate for use by more experienced writers who experience consistent covered call writing success and who are practiced at trade management. Less-seasoned writers have a tendency to panic, being aware that margin usage will increase the potential loss.
Now, before delving deeper into covered calls, we must cover other topics that inform proper covered call writing.