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This is another reason why I teach traders not to use naked option strategiesMARGIN REQUIREMENTS One of the most common questions asked by new traders when opening up a trading account deals with margin requirements. However, before we get started, let me state that there are minimum rules set by the NASD that govern margin accounts. Each firm, however, can set more stringent rules, so it is important that traders check with the brokerage firm they are opening an account with to find out its specific rules. As previously mentioned, a margin account is a type of account that allows traders to borrow money from the broker to leverage their trades. This seems like a great thing, and it can be; but margin can also work in reverse. It also means that a margin call might be made to tell you to put more money in to cover the losses. This is where margin accounts can become dangerous. If the stocks in your account drop sharply, like during a market crash, you can lose more money than you originally invested. This was one of the main causes of the stock market crash in 1929, because the margin requirement was only 10 percent at the time. Some traders might notice that even retirement accounts sometimes use margin accounts. This isnt because you have the ability to borrow money in these accounts, but because a margin account is needed to place the capital to trade strategies that have higher risk than the initial debit. This is another reason why I teach traders not to use naked option strategies. Not only is the risk unlimited with these strategies, but also the amount of capital needed to trade them is very high. Many traders might wonder what the margin requirements are for different strategies. This varies according to broker, but the easiest way to figure it is to calculate the risk the broker has. Whatever the maximum risk is will be the minimum amount of money the broker will want in your margin account. If you have any specific questions about the margin needed, just pick up the phone and call your broker. Stocks Based on the rules of the Securities and Exchange Commission and the clearing firms, margin equals 50 percent of the amount of the trade using stock. For example, if 100 shares of IBM at $100 cost $10,000, then you are required to have a minimum of $5,000 on deposit in your margin account. There are other levels, but the general public rule of thumb is leverage equals two to one. If the price of the stock rises, then everyone wins. If the price of the stock falls below 75 percent of the total value of the investment, the trader receives a margin call from the broker requesting additional funds to be placed in the margin account. Brokerages may set their own margin requirements, but it is never less than 75 percent, which is the amount required by the Fed. Margin on selling stocks short is extremely expensive. You have to be able to cover the entire cost of the stock plus 50 percent more. This value will change as the market price fluctuates. For example, if you wanted to short sell 100 shares of IBM at $100 each, you would need to have $15,000 as margin in your accountthats $10,000 plus 50 percent more. If the market price falls, you can buy back the shares at the lower price to repay the loan from your broker and pocket the difference. If the stock price rises, you will be required to post additional margin. Exactly how much is up to the discretion of your broker. Futures Margin requirements for futures vary significantly from market to market due to the volatility of the markets as well as the current price. A comprehensive margin commodity table detailing a variety of futures margins can be found at the Chicago Board of Trade (www.cbot.com) and the Chicago Mercantile Exchange (www.cme.com) web sites. You can also consult your broker for current margin requirements. Options Margin is used in a slightly different manner by options traders. Options are not marginable, meaning that the broker requires payment in full for an option purchase. However, when we trade a strategy that could cost us more than the original debit, we must have a margin account. The easiest way to look at this is to figure what the risk is to the broker. For example, lets say that I want to enter a bear call spread using 40 and 50 strike calls. I would sell the 40 call and buy the 50 call for a credit. Lets assume this credit is $2. This means that if the stock stays below $40 at expiration, I get to keep the entire premium. However, if the stock rises above $40 and ultimately moves above $50, I have reached my maximum loss, which is figured by taking the difference in strikes minus the initial credit. Thus, my maximum loss would be 8 points or $800 per contract. If I dont want to put this money in the account up front, I can use a margin account. However, the margin requirement should not be very large because the broker is at risk for only $800. This is where it is important to choose an appropriate broker. There are many brokers who will require an account value of $50,000 or more just to give you margin on an $800 trade. Most brokers who cater to option traders have less stringent demands; but its important to find out ahead of time how much the broker you are investigating requires to open a brokerage account. Selling naked optionsplacing a trade with unlimited riskhas the highest margin requirements. (I highly recommend that you never sell naked options. All short options should have a corresponding long option or stock to cover you against unlimited risk.) Combination Trades If you are hedging options, then the use of margin is up to your brokers discretion. While combining the buying and selling of options, stocks, and/or futures creates a more complex calculation, it can also reduce your margin requirements dramatically. These days, you have to find a broker who caters to option traders to make it in the volatile twenty-first century markets. An important rule of thumb: If youre worried about the margin at the onset of the trade, you should not be doing the trade. This rule keeps me away from putting on positions that are much larger than I can really handle. Obviously, the larger your capital base becomes, the less you worry about margin. However, its always in your best interest to look for the best tradeone with the highest return and the lowest riskno matter how much money you have available in your account. Individuals with large investment accounts may be tempted to make trades that are too big for their knowledge level. Start small. Build your account intelligently as you build your knowledge base. RISK, CONTROL, AND BALANCE When we have positions in the markets, we usually want to have a way of protecting ourselves from the worst possible scenario that could occur. The reason is so that we can preserve our capital and manage our risk exposure to the markets. But, why do we want to do this? Do we trade so that we can have an added element of risk in our lives? And, if the answer were yes, why would we want to limit that amount of risk? I think the answer may lie in what I call the balance between risk and control. This may also provide some insight into what compels a person to trade the markets. I remember as a child hearing stories about wild animals that, for one reason or another, came into the custodial care of a person. Maybe the person was trying to nurse the animal back to health or turn the animal into a pet. The thing that interested me most about these stories was that the animals would sometimes starve to death even though they had food to eat in front of them. One of reasons was that the animals needed to hunt their own food. Why? To me, it seemed obvious that it would be easier for the animal to eat the food in front of it than it would be to have to go through the difficulties of hunting for its food in the wild. Is the animals need to hunt greater than its need for food? I will leave that last question for the psychologists to answer. However, I think that we could agree that the animal would experience a higher degree of uncertainty and risk if it had to search for its own food. I think this need for the element of risk extends to people, but we also want to have a degree of control. I remember watching a television program several years ago about people bungee jumping off a bridge. A few months later, some entrepreneurs had set up platforms for bungee jumping in vacant lots of large cities. For a small fee, the thrill seeker would get a few moments of an adrenaline rush and the experience was over. While many of my friends classified this as a faked suicide attempt, I wondered if there was much difference between this and a roller coaster ride at an amusement park. There was an element of risk and control that each participant agreed to before either event occurred. Why is all of this important to trading? Most traders do not consider their reasons for trading. This is probably because they have never considered what their values and beliefs are about taking financial risks. They also seem to pay little attention to the parts of trading that they have control over. I am usually reminded of this fact when I talk with a trader about his methodology for trading. When the subject of risk and stop-losses comes up, there may be some element of apprehension that develops. This usually means that their stop-loss rules change from day-to-day or that no rules exist in their methodology. As a result, the limit for risk that the trader has is left for the markets to decide. This is because the trader has made a decision not to exercise control over the only thing that can be controlled once he or she is in the market: the protective stop-loss order. The only things that you have control over in the markets are your orders to enter or exit the markets and when you place the orders. Unless you have a risk-free options trade, there is never a guarantee of profits. There are three basic types of protective stop-losses for options traders: time, premium, and the price related to the stock. Most options traders should consider using all three techniques for each of their positions. Also, you should note that these techniques are elements of a trading plan that a trader has to act on. In that respect, these parameters are different than the typical stop-loss orders for buying or selling stocks. The protective stop-loss order for a stock may be placed immediately after the position is entered and may get automatically triggered days or weeks later if the market moves against his position. This is different from the type of stop-loss protection that I am talking about for options. For the options protective stop-loss, the order to exit the options position is placed with the broker after the stop-loss parameter is exceeded. The time stop-loss may be triggered when you have purchased an option and you want to exit the position in the last 30 to 45 days before expiration. This approach helps a trader exit the position when the options will experience the most time decay. However, this would probably not apply for all options spreads. For example, you would likely want a credit spread to expire in order to receive the full credit potential of the spread. If you are trading debit and credit spreads, you will likely have different time stop-loss parameters for both in your trading plan. Stop-loss parameters may also be based on options premium. When you have purchased an option or an option spread, you may want to exit the spread if the value of the position depreciates to a certain level. Also, you may want to distinguish between making this decision based on the options theoretical value or its actual value. If the option that you traded last week is no longer at-the-money, there may not be a lot of volume traded on the day you look at the markets. As a result the last traded price may not be relevant to the current market conditions. The third method would be based on the value of underlying stock. This method is usually employed when the trader has used some element of technical analysis in his or her decision to trade the stock. Since technical analysis is based on the stock price, the trader is able to determine the price at which the decision to trade the stock is no longer valid. This decision could be related to a moving average or a particular chart pattern. It helps the trader to quantify the price where the trader should exit the options spread. The effective use of protective stop-loss parameters in a trading plan has a correlation to the beliefs and values that the trader has about risk and control. When traders begin learning about the markets, they tend to look at the analysis part of the endeavor and as a result have a very leftbrain approach to trading. This leaves the trader open to self-sabotage because the very emotions, beliefs, and values that compel him or her to trade are not included in the initial training and assessment of the trading plan. We have all heard that trading is both an art and a science. Integration of the right-brain beliefs and values with the left-brain analytics helps the trader to create a trading plan where success is a function of technical decisions more closely aligned with their tolerance for risk. A final consideration when trying to mitigate risk is to avoid investing all or even half of your trading capital to one tradeeven if youre certain that its a sure thing. Allocate maybe 5 or 10 percent to each trade. That way, by diversifying and spreading your risk across many different strategies, one bad trade or idea will not clean out your whole account. CONCLUSION As a trader you must be aware of all the risksas well as potential rewardsof every trade you place. Understanding the risks, and most importantly, learning how to intelligently protect yourself are essential to successful investing and trading. To achieve success, you must become an avid risk manager. In the beginning, this will not be easy. Thats why its so important to start small. Mistakes will be made and you dont want your account to be wiped out before you get the chance to spread your wings. Since learning to protect yourself through creative risk management is the most vital part of successful trading, take the time to practice the art of risk management by setting up paper trades. Options are one of the most flexible financial instruments ever invented. They can be employed to reduce your risk exposure and potentially increase your returns, especially when playing the securities that have been beaten up without mercy. As Calvin Coolidge once said, Those who trust to chance must abide by the results of chance. Understanding how options interrelate and respond in different scenarios is the first step to managing risk while taking advantage of the opportunities that the current market presents. |
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