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Summary

  • Margin accounts can lead to reckless behavior.
  • Margin accounts can prevent "free riding violations."
  • Margin accounts can lead to increased income from put sales without incurring loan liability.

Last week one of my favorite people on Twitter, Eddy Elfenbein, said the following:

Based upon his past record of performance, Eddy Elfenbein is not a guy that you want to disagree with - and I don't. He is a consistently great source of insight.

With news that margin balances are once again at all time highs, you do have to wonder whether that's at least one sign of a market top, as it has its own history of reflecting the worst in individual investor excesses.

Having learned that the hard way in October 1987, I am, at the very least capable of learning from my mistakes and my long-term memory is still intact enough to offset my otherwise inconsistent judgment.

Elfenbein, who offered sage counsel in his Tweet, is an acknowledged and recognized master of "buy and hold" investing and offers as transparent of a past record as you could ever hope to find. He is also funny, knows his statistics and offers a free newsletter.

I, on the other hand, go from week to week, look to Jimmy Carter as my humor go-to guy, have forgotten the meaning of "kappa coefficient" and hide behind a paywall.

Actually, I am an occasional buy and hold investor, but prefer to do it in a syncopated fashion when possible, such as owning shares of eBay (NASDAQ:EBAY) 17 times in 15 months. That's almost like buy and hold.

After today's trading session, make that 18 times.

However, I do agree with Elfenbein that margin is dangerous, especially for the buy and hold investor, but I can't go so far as to say "don't."

For the covered option investor, the availability of a margin account brings very tangible benefits that can be consistent with the otherwise cautious nature of most such investors, and actually can even attenuate some of the risk associated even with some speculative positions.

The greatest value of a margin account for the cautious investor is helping to avoid "free ride violations."

As someone who frequently attempts to capture both an upcoming dividend and an option premium through the use of in the money call options, I run the possibility of having an option contract assigned early in an effort to capture the dividend.

For those unfamiliar with "free riding violations," that is the situation when stocks you have purchased with unsettled funds are sold before the funds ever settle.

"But that would never happen to me," you say?

"And besides, so what?"

As a covered call writer, I very often have lots of positions being assigned on Fridays. However, the proceeds from the sale of shares won't settle for an additional three business days. In the meantime, thanks to the largesse of the brokerage houses, you are given the opportunity to use those expected funds and purchase new shares before settlement.

That is a very, very nice thing to be able to do, especially if writing lots of weekly options and realizing that time value erodes quickly if you had to wait until Wednesday to buy shares and then finally sell your calls. Those lost days of time value add up to your detriment.

The caveat is that they will stop being so nice if you sell those very same shares before the funds have finally settled. If you do that, they don't call you what you are, that is a "freeloader," but rather cite you for a "free riding violation," and as a consequence you won't be allowed the privilege of trading with unsettled funds for a three-month time period.

However, if buying a dividend paying position that goes ex-dividend the next day using unsettled funds, you're in a position to have to sell those shares if assigned early, putting you in violation as a "free rider." I especially like trying to "double dip dividends" and try to get the best of all worlds, but am reluctant to pay the price of being labeled a "free rider."

Enter the margin account.

If you have a margin account, free riding isn't an issue. Not only can you sell your shares before the funds have settled, but you don't have to draw on your line of credit. All the brokerage cares about is that you have readily accessible and immediately available funds in your account and the line of credit that comes from your margin account satisfies that requirement, despite the fact that you don't have to draw upon it.

It's every bit as good as cash.

Last week I purchased shares of Best Buy (BBY), which was going ex-dividend on Tuesday. However, cash from assignment of shares of Coach (NYSE:COH), Kohl's (NYSE:KSS), Starbucks (NASDAQ:SBUX) and others the previous week didn't provide the cash needed to be able to purchase Best Buy shares outright, as a mini-spending spree added shares of a few other companies over the first two days of the week.

With shares of Best Buy going ex-dividend on Tuesday and having finished in the money on the eve of the ex-dividend date, it was at risk for early assignment.

Had that occurred, there would have been a very tangible and adverse impact on the ability to generate income streams from new weekly share purchases and sale of call options, if required to wait until Wednesday or Thursday of the week before cash from assignments settled.

Thank you, margin account. Not only for sparing me the ignominy of an unwanted label, but also allowing me to maximize my earnings and at no additional cost or risk.

Another tremendous benefit is the free use of money, especially if you are in the habit of selling puts, as I frequently like to do in advance or even after earnings are announced, or after any large adverse price movement.

The sale of cash covered puts can be a nice way to enter into a position at a lower price, however, it can also be a nice way of continually generating option premium without ever doing the responsible thing and taking ownership of shares, even if going below the strike price.

In a cash account, the brokerage escrows the amount that would be necessary to purchase shares if your puts are assigned. That's for everyone's benefit.

However, when using a margin account, all that occurs is that the margin available to you is reduced. However, as opposed to a reduction that comes about through the purchase of shares, you don't incur a loan related liability unless your puts are assigned.

However, if in jeopardy of being assigned the ability to rollover your put option to a forward week, perhaps even at a lower strike price can further generate premium income and still not incur any loan from your margin line of credit.

During a recent period I was able to do just that with Cree (NASDAQ:CREE), a marvelous company that simply goes up and down, and possibly manufactures something, as well. Sometimes information regarding the line of business just seems irrelevant.

click to enlarge)

In this case, put sales were initiated on 5 individual occasions. Sometimes the contracts simply expired, but one position illustrated above was rolled over on multiple occasions in an effort to avoid assignment and avoid incurring a margin obligation.

The example above is similar to other put sales undertaken, generally in highly volatile positions, including Herbalife (NYSE:HLF), Twitter (NYSE:TWTR), LuLuLemon (NASDAQ:LULU) and others, that allow me to achieve my 1% weekly ROI objective even when using well out of the money strike prices.

Recently, for example, while some may have been horrified to see Herbalife fall from $57 to below $50 in a single week, I rolled the weekly $50 put to a new weekly $47 put and just happily added to the weekly income stream without taking on the burden of a margin loan.

Reckless? Not really. Opportunistic? Absolutely.

Some may call that "free riding," but of a different variety.

Source: Margin Accounts For The Conservative Investor

Additional disclosure: I am short put contracts on HLF and TWTR and may sell puts in LULU.