THE OPTIONS COURSE- Margin and Risk

THE OPTIONS COURSE


Margin and Risk

When we refer to risk management, we speak of the ability to handle with a degree of skill the possibility of loss. Of course, when dealing with trading and the market, there are many kinds of risks. Overall, what we are trying to do is make money while at the same time managing the possibility of loss. This definition could be considered the Optionetics motto. Risk management isn’t the sexiest of terms; people don’t run out and study everything they can on the subject when they hear it. This has to do with the fact that risk management often discusses how to avoid losses, not how to make huge returns. 

Newsletters and stock-picking sites post claims of high returns on individual plays, but rarely state they controlled their losses with proper risk management. It just doesn’t sell. Baseball has taught us that people prefer a home run to four straight base hits, but a knowledgeable coach or trader knows that it’s the base hits that win games. Everyone wants to talk about the option play that made him or her 1,000 percent. But do these same people tell you about the other five plays that they lost everything on? Of course they don’t. 

Does risk management mean you can’t make large returns on your money? No, it does not. It means avoiding risks that do not make sense over the long term. Maybe the most common reason why option traders don’t last long is because they take too many risks. Even though they win occasionally, they end up running out of capital before the next home run is hit. Once you are down 5–0 in the ninth inning, that one home run is not going to win the game for you. I believe one of the most helpful concepts to understand is compound interest. Most of us profess to understand this concept, but if we did, we wouldn’t be so quick to take the risks we often do. 

Let me explain this with an example. If I put $1,000 in a trade and it returns 1,000 percent, I now have $10,000. Now that I have this extra capital, I decide to place $2,500 in four different trades, but each of these loses 50 percent of their value. I now have $5,000 left. If I had made just a 50 percent profit on each trade and compounded this growth each time, I would have more than $11,000. This is because of the compounding effect on my money. This is a very rough example. Obviously, taking all your winnings and playing it on one trade is not advised; but the point is that smaller profits that are compounded will create a larger account than risking too much to hit the home run. 

When was the last time you got a 1,000 percent return, anyway? In order to accomplish this task, too much risk is normally taken. At Optionetics, we teach that hedging in case of a loss is as important as getting out with a profit. None of us want to entertain the thought that we might be wrong about a trade, but the fact is that we will be wrong sometime and we need to be prepared for that event. On every trade we place, we should figure what our risk/reward ratio is. If we are risking $500 to make $100, is that a good risk/reward ratio? In general, the answer would be no. 

However, it really depends on the probability that the $100 would be made or the $500 would be lost. For example, what if you see an option trade that has a risk of $500, but this would occur only if a stock at 50 drops all the way to 35 in the next two weeks? The odds would probably say this risk is worth the reward because this drop is not likely to happen. This same philosophy holds true when looking at risk/reward of, let’s say, 10–1. This looks great, but if the stock needs to move 75 percent in a month to get this reward, is it really a promising risk?

Clearly, there is a lot to risk management. The underlying theme is to make certain you analyze the relationship between risk and reward. Understand that taking fewer risks and not holding on for the home run will benefit each of you in the long run. The Optionetics Platinum site has tools to help traders figure probabilities and risk/reward ratios that can make better traders of us all. So before you start visualizing that new car from the profits of one trade, realistically analyze the situation and make sure it really is the best move to make.

THE CONTEXT OF RISK

When you put on a trade, you need to look at the worst-case scenario to determine just how much your investment could possibly lose. Then you have to decide just how much you are willing to risk—$100, $1,000, or $10,000? When professional traders put on a trade, the first thing they look at (if they know what they’re doing) is the risk. For example, if you’re a trader with a large bank trading in currencies, you’re not trading just $100. You’re trading $10 million per contract. To be able to profitably handle such sums, these traders have to be able to manage their risk. 

The most profitable trades have two key elements: limited risk and unlimited reward. After all, you can create trades with limited risk all day long, but most of them will also have a limited reward. A $100 risk for a $100 reward is simply not acceptable. No one wants to risk $100 to get $100, even if you win 50 percent of the time. Only if you increase your winning percentage will it be an acceptable risk-to-reward ratio. Would you take a $100 risk for a $500 reward? I would. But how many times are you going to be right? That’s why it’s imperative to find trades with limited risk and strong rewards with a high probability of being correct.

I am frequently asked, “What will it cost me to invest?” This is a difficult question to answer. The necessary amount depends on a number of factors. The most important factors are the size of the transaction (number of shares/futures or options) and the risk calculated on the trade. As we discussed briefly in an earlier chapter, there are two types of transactions—cash and margin. Cash trades require you to put up 100 percent of the money. Margin trades allow you to put up a percentage of the calculated amount in cash, and the rest is on account. 

Both types of accounts are set up to settle trades and payments for trades, yet they are quite different. With a cash account, all transactions are paid in full by settlement day. Most of the time, the cash is already in the account before the trade is placed. If you bought 100 shares of IBM at $100, this trade would cost $10,000 plus commissions paid out of your cash account. If IBM were to rise to $110, your account would then show an open position profit of $1,000, or a 10 percent rise in the account. Let’s take a closer look at margin and how it can help improve the risk-reward ratio.

WHAT IS MARGIN?

Margin is defined as the required amount of cash on deposit with your clearing firm to secure the integrity of a trade. Most traders and investors prefer margin accounts in order to leverage their assets to produce a higher return. The amount of margin required on every trade is the calculated figure required by securities and commodities regulators, exchanges, and brokers to protect them from default. Margin is the amount required to protect these various parties against your “falling off the face of the earth.” A margin account allows the trader to borrow against the securities owned. 

In order to set up a margin account, you are required to fill out additional applications with your broker. You can use the money for anything you want; however, many traders use it as a type of leveraging vehicle with which to buy more stock. Margin accounts allow a trader to extract up to 50 percent of the cash value of securities, or to have two-to-one leverage in buying stocks. This means that for every share of stock you own, the brokerage firm will lend you money to buy another share. This doubles your reward, but also doubles your risk.

If you buy 200 shares of IBM at $100 using a margin account, this trade will cost $10,000 plus commissions ($20,000 ÷ 2), since the brokerage firm loans you the money to purchase half of this position. If IBM were to rise to $110, the margin account would show an open position profit of $2,000, or a 20 percent rise in the account, while you still have only $10,000 invested in this position. The margins on futures are significantly lower than the margins on stocks. The increased leverage that futures markets offer has contributed to their rise in popularity. 

As previously discussed, the margin requirements for futures vary from market to market. These requirements change frequently as the price of the commodity fluctuates. You should check with your broker to determine the current margin requirement for any futures you are considering trading. In most cases, if your trade starts to lose money, you will receive a margin call from your broker, which requires you to increase your margin deposit to maintain your position. When trading a margin account, brokerage firms charge interest against the cash loaned to the trader. 

The interest rate is usually broker call rate plus the firm’s add-on points. The rate is lower than for most loans due to the fact that it is a secure loan. The broker has your stock, and in most cases will get cash back before you get your stock back. Keeping your margin requirement low is essential to lowering stress. Many people find it difficult to stay in a high-stress trade. They think about it too much, fretting about how they might lose $5,000. After all, it took them two months to earn that $5,000. Suddenly, they’re out of the game. Lowering your stress gives you a clear mind with which to make good decisions. 

When you put on a trade, try to keep the cost of capital as low as possible and the return on your investment as high as possible. Maintaining a low margin is the natural extension of limiting your risk. If you are buying options as part of your delta neutral strategy, or doing futures with options, your margins should be pretty close to zero. You will, however, have to pay for the options in full. Now, as the trade starts working, if your futures side makes money, you shouldn’t really have to add any more money to your margin account. However, if your futures side is losing money, you may have to. 

There’s nothing like receiving a margin call in the early hours of the morning to ruin your whole day. If you have a $100,000 account and you spend $50,000 on your options, there is still $50,000 in your account to support a losing futures position. The problem is that in the options market you cannot touch your long option value, although it is probably keeping pace with the futures loss. It is almost like it’s in escrow. It’s there, but you cannot touch it. The only way you can get to it is to exit your position. 

You may have to add more money temporarily to your account to stay in the trade. If money were absolutely no object whatsoever—go ahead and dream big—then you wouldn’t care if you had to feed your account. You’d probably be better off if your option side was the one working because of the long gamma. For example, let’s say you initiate a delta neutral trade with ATM options. As the market goes up, your options are getting longer and longer, which is definitely the preferable position to be in. 

Unfortunately, for most of us money is not only an object, but also the driving force behind many of our decisions each and every day. When you are choosing which side to concentrate on—the long side or the short side for your futures—keep in mind that you may have to add more money. This is why it is sometimes beneficial to try to forecast market direction. Loans against your securities do not have any scheduled payments. Therefore, you can pay back your loan on your terms. Borrowing from your margin account also has tax considerations if you have stock that you do not want to sell.

If the perceived risk of your trade increases, then the margin requirement will also increase. If you have enough money in your account to cover the increased perceived risk, then you won’t be required to put up any additional cash. However, if you do not have the cash required to cover this additional perceived risk, then you will get a margin call. A margin call is a call from your broker requiring you to place additional funds in your account. If you do not place these additional funds in your account, your position will be liquidated. (If you bought something it will be sold, and if you sold something it will be repurchased. This will close out your position.)

Why should you be concerned about margin? Most new investors and traders rarely consider the margin other than from the standpoint of how much money they have to put up initially. However, an investor or trader should look at margin as a cost of doing business. There may also be opportunity costs incurred by placing a trade. In other words, the best way to make money over the long term is to use limited resources (capital) to achieve the highest return with the lowest risk over the shortest period of time. 

You may have a chance to put on 10 different trades, each with different risk/reward and timing profiles. Each potential trade should be placed in order of the highest return on capital with the least risk. New investors or traders need time to figure this out. However, once you reach a level of proficiency sufficient to understand and numerically calculate these levels and categorize them, you will achieve your goal of generating the highest return while minimizing your risk. Let’s take a look at the established general margin requirements. Then we will explore some examples of capital analysis.

MARGIN 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 isn’t 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 account—that’s $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 and the Chicago Mercantile Exchange. 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, let’s 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. Let’s 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 don’t 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 it’s important to find out ahead of time how much the broker you are investigating requires to open a brokerage account. Selling naked options—placing a trade with unlimited risk—has 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 broker’s 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 you’re 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, it’s always in your best interest to look for the best trade—one with the highest return and the lowest risk—no 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 animal’s 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 option’s protective stop-loss, the order to exit the option’s 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 option’s 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 trade—even if you’re certain that it’s 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 risks—as well as potential rewards—of 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. That’s why it’s so important to start small. Mistakes will be made and you don’t 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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