Leverage and Margin in 2019: The Definitive Guide - Option Posts

Leverage And Margin In 2019: The Definitive Guide

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Leverage and Margin

This is the most comprehensive guide to margin trading on the planet.

The best part?

I’m going to show you how to safely use margin and leverage to enhance your portfolio returns.

In short: if you want higher portfolio returns, you’ll love this guide.

Let's get started.

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1

Margin Trading Basics

In this chapter I’ll cover the basics.


First, you’ll learn exactly what a margin trading is.


I’ll also explain why buying on margin is so important for enhancing portfolio returns.

What is margin trading?

The answer depends on what financial instrument you are trading (stocks vs options vs futures).

I’ll explain the details of each type of asset later on.

One thing they all have in common is that margin reduces the capital requirement needed to trade the asset.

This is because you are essentially borrowing capital from your broker. So, you can think of margin as your “down payment”.

Margin

Margin refers to the capital required to trade a financial asset. 

This gives you financial leverage. I’ll explain a little later in this post what financial leverage is and how it ties in with margin trading. (this is how you enhance your portfolio returns) 

Why is margin so important?

Like I mentioned, margin allows you to control more assets for less capital upfront.

So the more margin you can get, the greater the potential for higher returns.

However, there is a dark side to trading with large amounts of margin. That is also a greater potential for higher losses.

This concept may not be as foreign as you may think.

If you’ve ever bought real estate using a mortgage, you can think of your down payment as margin. By borrowing money from the bank, you can control and take ownership of the house, without having the pay the full value out of pocket.

The question is:

How is margin treated differently between the different types of financial assets like stocks, options, and futures?

And how do you safely use this margin to increase portfolio returns, while avoiding all the risks?

Well, that’s what the rest of this post is all about.

2

Buying Stocks On Margin

Out of all the different types of financial assets, stock margin gives you the least amount of leverage. 


However, a little bit of leverage goes a long way. 


In this chapter, I’ll show you the nuances of buying stocks on margin.

You can very much think of stock margin as a loan. In fact, some people call it a margin loan.

This is when your stock broker lends you some capital to buy stocks on margin.

How much money will your broker lend you?

The answer is 50% of the value of the stocks.

Here's an example

Let’s say you have $10,000 in your trading account.

 

Your broker will allow you to purchase $20,000 worth of stocks. This is because they will lend you the extra $10,000 that you don’t have in the form of a margin loan.

 

So, in stocks, your leverage ratio is 2:1. You can buy 2 times the amount of stock relative to the amount of money you have in your account.

The Cost of Stock Margin

The broker is absolutely not going to lend you that money for free. They’re going to charge you interest on that loan.

It’s not cheap either. Interest rates on margin loans range from 6%-12% depending on the broker.

Stock Margin Rates

Buying stocks on margin is mainly used to short-term trades because the more interest charges you accrue, the greater the return you need just to breakeven.

If your broker charges you a 6% interest rate, your stock returns need to be at least 6% just to breakeven.

This does not seem like a good deal, when the majority of the time, the stock market only returns 7% on average.

If this were the case, you would only net 1% on your investment.

So, why would anyone want to buy stocks on margin?

I’ll cover the answer to that in Chapter 6.

3

Options Margin

In this chapter, I’ll reveal who options margin is not really a loan like with stocks.

 

The best part? Options margin typically give you 5:1 leverage, which is better than stocks AND you don’t have to pay any margin interest.


Let’s dive right in.

There are only a few scenarios in options trading where you “trade on margin”.

That is only if you sell naked options that undefined risk.

Undefined Risk Options Strategies

These types of strategies theoretically have unlimited risk. 


Here are a few examples:


  • Naked Call
  • Naked Put
  • Strangle
  • Straddle
  • Ratio Spread

If you buy options or trade defined risk strategies, you don’t use margin at all. This is because the broker requires you to set aside 100% of the maximum loss on the trade.

With buying options and other defined risk strategies, your maximum loss is known prior to initiating that trade.

So, to make sure you are able to absorb any potential losses, your broker will make you set aside that amount.  

What’s the difference with undefined risk options strategies?

Well with undefined risk strategies, you theoretically have an unlimited loss potential so it’s not as simple as setting aside your maximum loss potential.

Instead, the broker will require you to set aside approximately 20% of the stock price for 100 shares of stock. (remember 1 options contract is equal to 100 shares of stock)

Where does the broker come up with this 20%?

The answer is a little complicated because it has to do with the implied volatility of the stock and the standard deviation.

The broker wants you to be able to cover a two standard deviation move, or about a 95% probability range.

Here's a quick example

Let’s say you sell a 100 strike put option, with the stock price at $100 and an implied volatility of 10%.

 

A two standard deviation move would mean the stock price would move up or down 20%.


If the stock price were to go higher, you would profit so there’s nothing to worry about there.

 

Your risk on this position is to the downside. So, what magnitude of a loss would you have if the stock price were to drop 20%?

 

Well, the stock price would drop $20, giving you a loss of $2,000.

 

Therefore, the broker will require you to set aside $2,000 in margin to initiate that trade, just in case that trade happens to be a flop.

You don’t actually need to come up with this number on your own.

In fact, all options brokerages will automatically calculate this number for you based on their own proprietary risk models.

So, the 20% is just a rule of thumb.

This means that in general, leverage in the options world is about 5:1.

Is options margin a loan?

Unlike stock margin, options margin is actually not a loan.

Remember, options are contracts to either buy or sell stock at a certain price by a certain date in the future.

When you sell options, you are obligated to perform on the contract.

You can think of options margin as a good faith promise to make good on your contract (to either buy or sell stock).

Because it’s not a loan, you don’t pay interest directly in this scenario.

If you’re familiar with the Black-Scholes options pricing model, one of the key inputs into the model is the interest rate. This is where the interest costs is taken into account.

In order to trade options strategies that require margin, you need to open a margin trading account.

If you have a cash account or an IRA account, you cannot obtain margin so you cannot trade these types of options strategies.

I’ll lay out how to open a margin account in Chapter 8.

4

Future Margin - The difference between maintenance and initial margin 

Margin in futures trade is yet a little bit different than what I had talked about for stocks and options.

 

In this chapter, I’ll explain margin in the futures world.

Similar to options margin, futures margin is a good-faith deposit or the amount of capital needed to control a futures contract.

Remember:

Futures contracts are obligations to either buy or sell the underlying asset at a future date.

To make sure that you will make good on your obligation and be able to adsorb and losses, your broker will require you set aside some capital for margin.

In fact, this is called the initial margin (amount of capital required to initiate a futures position) or performance bond by some.

This number is determined by the futures exchange and varies depending on which futures contract you trade.

With futures contracts, there is also a second type of margin number that you need to be aware of.

This is the maintenance margin.

Maintenance margin is the lower amount an account can reach before needing to be replenished.

You can think of this amount as the minimum balance you need in your account to hold onto your futures position.

If your account balance goes below the maintenance margin, you’ll have something called a margin call.

I’ll discuss a margin call more in depth in Chapter 7.

Definitions

Initial margin: The amount of margin required to initiate a futures position.


Maintenance margin: The amount of margin required to maintain a futures position.

Once you liquidate your futures position, you will be refunded the initial margin plus and gains or minus any losses you may have incurred in the trade.

Both the initial margin and maintenance margin are determined by a mathematical formula, which I’ll cover next.

How is futures margin determined?

The futures exchanges use something called SPAN margin.

SPAN Margin

SPAN Margin - Standard Portfolio Analysis of Risk.


This is the math model the futures exchanges use to determine futures margin.

SPAN margin is a mathematical model that takes into account factors like price changes, volatility changes, and time to expiration.

In fact, it is a model that runs over 16 different market scenarios to determine what is the worst possible loss in a one day period.

SPAN Margin CME

What does this all mean?

This means that futures margin can fluctuate - sometimes even drastically as volatility expands and contracts.

As volatility of the underlying asset increases, margin will also increase.

As time to expiration decreases, margin will increase.

Because of the potential for margin to grow, it is important to keep capital available just in case.

How SPAN Margin Benefits The Futures Markets

At first glance, it may seem that SPAN margin might not be good because of its ability to change overnight, but there is a good reason why it is that way.

Let’s take a look.

The futures exchange acts as a guarantor for all futures trades. In order for the futures exchange to do this, all market participant must set aside their initial margin.

This stabilizes the financial integrity of the futures exchange, effectively eliminating counterparty risk.

Counterparty Risk

Counterparty risk is risk to each party in a financial transaction that one party does not fulfill its contractual obligations.

By being required to set aside the initial margin, the futures exchange will have enough capital to make good on their contract obligations in the event that one of the market participants goes belly up.

Futures and Leverage 

Margin in the futures world hovers around 5% of the notional value of the contract.

This means that you need to put up $5 for every $100 worth of assets you are controlling.

In leverage terms, you are levered 20:1. Out of all the asset classes discussed so far, futures is by far the most levered financial asset available.

The exact amount of leverage will depend on which futures contract you are trading and all the other factors that go into calculating SPAN margin.

Why does SPAN margin affect leverage?

It’s because SPAN margin can fluctuate. If margin goes up, your leverage goes down because you are required to set aside more capital. If margin does down, your leverage goes up because you can set aside less capital.

5

Margin Trading Bitcoin

Bitcoin and other cryptocurrencies have gained tremendous popularity - even to the point where cryptocurrency exchanges began to offer margin trading for bitcoin to enhance portfolio returns.

 

What you didn’t know is that it actually hurt many cryptocurrency investors who were caught by surprise.


Let’s take a look.

In 2017 and 2018, there was some massive hype around Bitcoin because of its 1000%+ price increase in a short period of time.

Margin Trading Bitcoin

In fact, several cryptocurrency brokers allowed its customers to trade Bitcoin on margin.

This way its customers could enhance returns as the priced rapidly increased.

The situation for trading Bitcoin on margin is very similar to trading stocks on margin, so I won’t go too in depth on it here. 

Eventually the cryptocurrency bubble burst causing losses for many investors.

What made it worse was that many were levered up into the up-move in Bitcoin. So when the price of Bitcoin began to decline, many investors receive magnified losses on the way down.

After a 30% flash-crash, many cryptocurrency exchanges removed trading on margin to alleviate some of the risk.

Until the volatility of cryptocurrencies subsides, you should take precautions before margin trading Bitcoin.

6

Leverage and Return on Capital

To this point, you have learned how margin trading works for several different asset classes.

 

Why would anyone want to trade on margin?


The answer is because it magnifies your portfolio returns.

 

Let’s take a look how that works.

Financial leverage means you are controlling more assets with less money.

All the scenarios I’ve outlined so far, have been where you only have to set aside a fraction of the total value of the assets to control those assets.

Let’s walkthrough an example how leverage magnified your gains.

Financial leverage example

Let’s say you buy $1,000 worth of stock with 2:1 leverage.

 

This means you only have to set aside $500 from you account to purchase $1,000 worth of stock because your broker will lend you the extract $500.

 

Let’s say the stock price rises 10% - so the $1,000 of stock you bought now has a market value of $1,100.

 

That results in a gain of $100. But you only had to set aside $500 from your account to initiate the trade.

 

This means you made a 20% return on capital.

 

What if you hadn’t used leverage on the trade?


Without leverage, you would have to set aside $1,000 to buy $1,000 worth of stock.

 

If the stock price rises 10%, you made $100. The exact same as the previous case.


However, you had to set aside $1,000 to initiate the trade, so your return on capital is only 10%.

Here’s a table to illustrate how leverage works for the different asset classes I have discussed:

Stocks

Options

Futures

Bitcoin

2:1 leverage

5:1 leverage

20:1 leverage

3:1 leverage

$1,000 value

$1,000 value

$1,000 value

$1,000 value

$500 investment

$100 investment

$50 investment

$333 investment

20% return

50% return

200% return

33% return

This table shows you what financial leverage means. You can achieve more will less.

However, there is a dark side to leverage that you must consider in your trading plan.

That is the fact that leverage can also magnify your losses, just as it had magnified your gains.

That’s what I’ll cover in the next chapter.

7

When Leverage Goes Bad - Margin Call

You won’t always make profitable trades.  


In fact, leverage is a double-edged sword that can also magnify your losses.


I’ll explain how.

Just how leverage can magnify your gains, it can magnify your losses.

What happens when your margin gets wiped out in financial losses?

Let’s take a look.

Let’s say you bought $1,000 worth of stock with 2:1 leverage, so you only have to set aside $500.

If the stock price were to fall by 50%, your $500 in margin will be completely wiped out causing you a 100% loss.

What happens if the stock price were to continue falling?

If the stock price were to fall 60% you would in fact owe the brokerage firm $100.

This is leads us to a margin call.

Margin Call

A margin call occurs when your brokerage firm requires you either to liquidate your position or add more funds to your account.

If you ever have a margin call, you basically have to add more funds to your account or liquidate the position.

This is because the broker can force you to add more money into your account should your account balance fall below a certain level.

So, yes. Buying stocks and other assets can be very risky.

How To Safely Use Margin

Like all things that can be abused, margin and leverage is no different.

You can reap significant reward by using leverage.

But to safely manage your risk and avoid owing money due to a margin call, it is extremely important to keep your position size small.

By keeping your position size small, you are able to withstand a drawdown, should you incur losses on your trade.

8

Margin Accounts

There is a specific type of trading account that you need to get trading margin.


This account is called a margin account.


Let’s dive into what the requirements are for this type of account.

A margin account is a type of trading account that allows the use of margin (borrowing of money) to trade different types of financial assets.

In order to open a margin account, you need to fund the account with $2,000. This is a FINRA rule to protect novice investors from the risk of substantial losses.

Additionally, you typically need to sign additional paperwork acknowledging that you are trading leveraged products and the associated risks.

In this type of trading account, you can trade pretty much any strategy or underlying without restriction.

This is unlike IRA accounts and cash accounts where you cannot trade naked options strategies or futures contracts (in cash accounts).

Now It's Your Turn

I hope this guide showed you what margin and leverage are and how to safely use it in your trading accounts to enhance your returns.


And now I’d like to turn it over to you:


Did you learn something new from this guide?


Or maybe you have a question.


Either way, let me know in the comments below right now.

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