It's almost a badge of honor among very conservative traders and investors to say they don't ever trade on margin. I've said it myself. Of course, it's not really true. I trade options. In doing so, I must meet and maintain my broker's margin requirements all the time. What I really mean is that I don't borrow money to purchase stock, paying interest for the time I maintain the loan. Instead, I sell naked puts. On the surface, they seem like two completely different strategies. But I don't think they are as different as one might think.
Here's the basic premise. Let's say most of my money in my account is tied up in positions, but for some reason, I have my heart set on picking up some shares of company X. For the sake of this article, we'll say I want to pick up an additional 500 shares of Adobe Systems Inc. (ADBE) to add to the 500 I already own. However, I don't want to spend the money for the other 500. I'd rather keep that capital active somewhere else. I could simply borrow the money, and pay the brokerage interest on my borrowed money. Assuming ADBE travels upwards, I could make quite the return on my investment. If ADBE were to rise 10%, I would make 20% minus interest on my total holdings.
Of course, with this opportunity there is significant risk. I want that significant return, but there's no guarantee that ADBE will rise anytime soon. And while I wait, I pay interest. If ADBE should dip, I could be forced to pony up more money to maintain my position.
Luckily, I have options (omit cliché pun statement). I can sell 5 contracts of puts, covering 500 shares. By selling puts, I'm obligated to purchase the 500 shares from some lucky seller, should he/she decide to execute the option. In exchange, I get paid to commit to the contract and take the risk of plummeting ADBE share price. Whether I purchase 500 shares now, or whether I sell puts that cover 500 shares, my ultimate risk is that the stock goes to zero. Of course, in one case I lose everything and I get to pay interest on my borrowed dollars, and in the other case I lose everything, but I keep the option premium. I imagine that if that nightmare scenario was to occur, and I was to lose close to $32,000, the few hundred extra dollars the options would have netted me wouldn't provide me much relief. But now that we see that our total loss scenarios are similar, let's take a look at some more likely results.
I'll use the purchase of 500 shares of ADBE as our baseline position. I'll use a snapshot of Thursday May 24th, and the nearest ADBE option expiration date available is 16 June. Therefore, I'll use 23 days as our anticipated closure date for the trade (just to simplify things). Currently, ADBE stock price is $31.69, so purchasing 500 shares will cost us $15,850, and we will borrow the same amount. The quoted interest rate for my brokerage is between 6.25 -9.00% depending on the balance in the account. I'll use 7.50% for my comparison. By the way, I know these rates seem very high compared to what some on SA have said they get from their brokerage. I can only use what is quoted on my broker's website.
Using these numbers, I determine that I will owe my brokerage $74.91 at the end of 23 days. That's $15850 X .075 /365 X 23 days. That is only .47% on our 500 shares, but I'm down before I even own the shares and that's not counting trading costs and slippage.
What if I instead elect to sell 5 put contracts with an expiration date of 16 June, and a strike price of $31.00, giving some lucky buyer the right to sell me 500 shares of ADBE, should he/she decide to do so. Each put contract nets me $69.00, or a total of $336.15 after fees. That comes out to a cool 2.16% for those 23 days (based on the $15,500 now risked), or 34.28% annually. For my margin strategy to yield me the same percentage return on my risked assets, ADBE must rise by 2.65% in the next 23 days [($15850+$74.91) X 1.0216) /$15850)] to beat our put return.
Furthermore, any drop in price will significantly increase the difference in performance, with our put trade continuing to offer us a profit until ADBE falls below $30.31 ($30.33 including the fees I would be charged). For those unfamiliar with a put's profit pattern when compared to a long position on equity, here's a graph:
Even after the put strategy begins to lose money, we can see from the graph (and our own calculations) that our return will still be superior to holding the position, and paying interest on it.
We would need to be pretty certain of the stock's imminent rise within our time constraints to warrant borrowing the money rather than selling the put. Yet, if we are so certain ADPE is about to jump in price, we can always sell the put in the money. By selling 5 16 Jun puts with strike prices at $33.00, we can net $173 per contract. If we are right that ADBE is about to jump rapidly, our margin stock option would have to leap past $33.56 in the next 23 days to beat our put position.
As you can see from the above graph, we've sacrificed any buffer on the downside that we might have had. ADBE must rise for us to make any money. But the risk doesn't come from the option position; it comes from our refusal to accept that we may be wrong directionally, and our desire to capture gains over accepting downside protection.
Selling naked put options is an obligation. Should the underlying stock plummet, you are subject to the option being exercised, just as the margin trader is subject to margin calls. Therefore, you should enter the trade with a plan on where you will obtain your funds. What positions are you willing to sell to raise money to purchase the shares just put to you? If the answer is none, then you should reassess whether trading that particular position is worthwhile at all. After all, if ADBE is the least attractive trading option in your bag of tricks, why is it the one you are leveraging?
In addition, you need to prepare for a very nasty market drop. When calculating leverage in regards to puts, I do not use my broker's rules to determine my limitations. For the above scenario, the margin requirement for my broker would be $395. If I'm relying on margin requirements to limit my leverage, I could find myself selling all my positions to cover my put obligations in losing trades. Instead of $395, if I've sold the $31 call in the example above, I would consider that $3100 leveraged for every contract sold. I allow myself anywhere from 15-25% leverage, depending on whether I think the market is over or undersold. I would never exceed 25% of your portfolio's value in naked puts measured by the amount you'd have to pay if every one of them was exercised at any moment.
Put options tend to be a great way to leverage your portfolio, and speculate on a position when you don't have the free capital to do so without borrowing money. Puts tend not to be exercised until the last minute because the buyer of the put would rather sell the option to keep the time value, and, unlike calls, exercising the option can only cause him/her to lose any dividends/distributions etc, not gain them. I don't recommend most people sell deep in the money puts, especially with so little time left to exercise. But if the choice is between a margin position, and selling puts naked, I'll take the naked puts any day of the week.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.