Portfolio Margin - Useful and Dangerous Leverage

by OptionSage - February 7th, 2009 9:16 am

Give me a lever long enough and a place to stand and I will move the entire Earth

 - Archimedes

 Margin Basics

Whether you examine the property portfolio of a real estate tycoon or the portfolio of a successful private equity company, you will find a common thread that magnifies returns for each… leverage!  It is no different in the stock market.  In fact, each of us who trades options takes advantage of the leverage they afford us every day.

Leverage simply means using financial instruments, or borrowed capital, such as margin, to increase the potential return of an investment. 

Since we spend our days on the member’s site discussing leverage through options, the use of margin sometimes gets less attention than it should, so here’s a quick refresher:

 1.You CAN use margin (borrow from your broker) to purchase stock.

2. You CANNOT use margin to purchase options but there are MARGIN REQUIREMENTS for certain spread positions that we like to take.

This is intuitive when you think about the movements of options relative to those of stocks.  Options can move by 20%, 50%, 100% or more on any given day, even if the underlying stocks move just a fraction of those amounts.  In fact, the frequency with which a stock will drop 50% in price in a very short time period is so low that brokers are currently willing to lend you your entire cash reserves to purchase stock.

Example

If you were to deposit $100,000 in your account, you can borrow another $100,000 from your broker to purchase more stock.  This is represented in our account as follows:

Cash:  $100,000

Stock Buying Power:  $200,000

Option Buying Power: $100,000

Let’s assume we purchase 2,000 shares of a $100 stock, costing us $200,000.  If the stock doubles in value to $200, our $200,000 turns into $400,000 and since we borrowed $100,000 from our broker, we can pay that back with interest and keep the remaining $300,000 (minus interest).  So, the stock went up 100% and our account went up 200%%!

The benefit of margin is obvious but it doesn’t come without drawbacks.  Had the stock dropped by 50% from $100 to $50, the $200,000 would have turned into $100,000 and since $100,000 was borrowed, the broker will issue a margin call and take back its $100,000 leaving us with $0!  Hence, both the risks and rewards are magnified if we fully use margin under the current system.

Margin Calls

Despite its potential rewards, buying on margin can be very risky. For example, the value…

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The Dawn Breaks…

by OptionSage - January 19th, 2009 11:47 pm

The hammer dropped Thursday.  The market held firm Friday.  And this next week will be seen in retrospect as the week the market bottomed out and started to rise again - at least for quarter 1 2009. 

Detractors might argue that Circuit City is laying off thousands and Bank of America might be closing locations and commercial real estate is dead and shopping malls are vacant and….

And it may all be true.  But the beauty of integrating fundamental and economic analysis with technical and sentimental analysis is that the big picture appears.  The fundamentals of many stocks are certainly impaired.  Even Kudlow will find it hard to argue in favor of a bullish economy.  But the sentiment is changing.  Watch the VIX over the next few months.  I anticipate it will be lower by March than where it is now even if not within the next few days.  And the technical charts tell stories once you know how to read them.  The news is reflected in the charts and the story the charts tell is bullish.  The markets should go higher in the next few months. 

Can I be certain?  With 100% probability, no!  But actions speak louder than words.  And as the dawn breaks on the coming week I plan on backing the rhetoric with purchases and those purchases shall be on the SSO to amplify the expected gains.  And what of Gold…Gold goes higher too.  Time to get on board the train to $1,000/oz.

To confidently predict direction is not enough.  I need to know I can figure out how to protect myself if I am wrong.  That’s how I made money in 2008 when most lost their shirts.  All you need is a system that works.  And the system I use I also teach.  If you’re interested you too can thrive and prosper.

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Bankster Quotations

by OptionSage - January 17th, 2009 1:47 am

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered."  Thomas Jefferson   "I sincerely believe that banking institutions are more dangerous to our liberties than standing armies.  The issuing power should be taken from the banks and restored to the people to whom it properly belongs"  Thomas Jefferson   "History records that the money changers have used every form of abuse, intrigue, deceit and violent means possible to maintain their control over governments by controlling money and its issuance" James Madison    "Most americans have no real understanding of the operation of the international moneylenders…the accounts of the Federal Reserve System have never been audited.  It operates outside the control of congress and manipulates the credit of the United States." Sen Barry Goldwater   "Neither a borrower nor a lender be" (Shakespeare)   "The Federal Reserve definitely caused the Great Depression by contracting the amount of currency in circulation by one third from 1929 to 1933"  Milton Friedman   "If our nation can issue a dollar bond it can issue a dollar bill.  The element that makes the bond good make the bill good also.  The difference between the bond and the bill is the bond lets money brokers collect twice the amount of the bond and an additional 20% whereas the currency pays nobody but those who contribute directly in some useful way"  Thomas Edison   "It is absurd to say that our country can issue $30m in bonds and not $30m in currency.  Both are promises to pay, but one promise fattens the usurers and the other helps the people"  Thomas Edison   "We have come to be one of the worst ruled, one of the most completely controlled governments in the civilized world - no longer a government of free opinion, no longer a government..by a vote of majority, but a government by the opinion and duress of a small group of dominant men" President Woodrow Wilson   "The Federal Reserve Board has pumped so many billions of dollars into Germany that they dare not name the total"  Senator Louis McFadden prior to WWII   "The powers of financial capitalism had (a) far-reaching aim, nothing less than to create a world system of financial control in private hands able to dominate the political system of…

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Danger + Opportunity

by OptionSage - December 20th, 2008 2:19 pm

This same spirit can be the catalyst to success in spite of the perils that may lie ahead. It is well known that in Chinese the word crisis is written as a composition of symbols representing ‘danger’ and ‘opportunity’. But preparation is a pre-requisite to taking advantage of opportunity. So, although the danger may be high, opportunities will present for those who are prepared. And to truly be prepared one must have the knowledge necessary to succeed. The entire faculty of traders at Stock and Options Training are still in the black in ’08. And frankly we’re feeling a little guilty that we’re in…

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Danger + Opportunity

by OptionSage - December 20th, 2008 2:16 pm

 As 2007 drew to a close, Phil predicted ‘Asian-style’ moves in US indexes and I wrote an article projecting 2008 would be a very difficult year to trade due to ‘unprecedented volatility’. As 2008 draws to a close it looks like both predictions were realized but pleasure does not necessarily accompany vindication. As John Maynard Keynes wrote: 

This same spirit can be the catalyst to success in spite of the perils that may lie ahead. It is well known that in Chinese the word crisis is written as a composition of symbols representing ‘danger’ and ‘opportunity’. But preparation is a pre-requisite to taking advantage of opportunity. So, although the danger may be high, opportunities will present for those who are prepared. And to truly be prepared one must have the knowledge necessary to succeed. The entire faculty of traders at Stock and Options Training are still in the black in ’08. And frankly we’re feeling a little guilty that we’re in the…

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A MUST Read!

by OptionSage - October 3rd, 2008 11:06 pm

"Life will teach you the lessons, it’s up to you to learn them"  

Don’t read any further if you are happy with your trading results this year.

If you know in your heart you could have done better trading this year then you MUST learn a lesson from your trading performance.  You MUST or are you are destined to repeat it again.  And if it feels painful the first time, it will feel much more painful next time around!  The lesson you MUST learn is simple but immensely powerful; it is truly a paradigm shift in trading. 

You MUST learn to adjust your trades to the market trend.  That’s it.  If you understand what that means and how to successfully execute, read no further.

What does this ‘adjusting’ really mean?  It means no longer buying and hoping, it means no longer is a binary trading system appropriate; binary meaning no longer will you win if you are right and lose if you are wrong.  What if you could screw up on picking the direction and still win??  Well, you can when you know how to ‘adjust’  to the market trend. 

The power of knowing how to successfully and competently adjust is immeasurable.  At the very least what it accomplishes is ZERO fear and ZERO greed.  When you pre-define your risk and reward levels prior to every trade AND know exactly what Contingency Exit Plan you should execute EVEN if you are wrong, you reach a trading level few will ever conceive of - let alone reach. 

You can learn how to do this from the masters but the knowledge is guarded by most and the cost to learn is usually very expensive because you will rarely be told everything at first (and will be charged more to learn the rest!).

So, why am I telling you all this?  Because I paid the price.  I learned a most powerful trading system of adjustments which I am confident is truly the last trading system anybody needs to know.  I learned it so well, I was invited to start hedge funds and teach around the world.  But as the days went by this past year and I realized how tough trading was for many friends and how they were losing their shirts I decided I had to get the knowledge to everyone without them paying crazy fees. 

And then BAM!  Like lightning the idea came to me and I started Stock and Options Training, a company  where real traders like you can learn…

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Trivia Time!

by OptionSage - August 18th, 2008 11:37 pm

Let’s say you decide to deposit $100,000 into a brokerage account.  You decide you will check your portfolio on a weekly basis.  Now let’s further assume that the first week has passed and you are about to log in to your account.  But before you do, you are told that one of two things has happened in the past week.

[1]  Your portfolio went up $10,000 and then dropped $10,000

[2]  Your portfolio went up 10% and then dropped 10%.

So, the trivia question is:  In case [1], what should you expect your account value to be and is that the same figure as in case [2]?

If you answered $100,000 in case [1], you would be absolutely correct!  If you answered that this is the same as in case [2] you would be absolutely incorrect!  Why?  Well let’s take a look at what happens when the portfolio rises 10% first; it goes from $100,000 to $110,000.  But then we’re told it drops 10%.  10% of $110,000 is $11,000.  So the portfolio drops from $110,000 to $99,000. 

Now how can this help us in our trading decisions?  In its simplest form, this tells us that if we were to simply buy stocks that over the long run had a tendency to rise up substantially and fall down substantially ie starting at 0% and rising up and ultimately falling back to 0%, the volatility is impacting long-term returns.  In statistics, that percentage swing would denote variance, which in turn is often equated with risk.  Another term for risk is beta.  High beta stocks tend to move more than the market and tend to have greater variance.

So, if you are in the market for the long-term, you should certainly pay close attention to the impact of variance.   Over time the impact to the $100,000 portfolio is not just a drop of $1,000 as in the period shown above, but that portfolio erosion continues over time to the detriment of overall wealth.  Unless….

Unless, you know how to take advantage of such volatility.  Buying and holding stocks is about as advanced a trading technique in this day and age as owning a cell phone that simply operates as a phone.  Why accept bare functionality when you can combine the basics with so much more.  In the stock market, this means using options.  (In cell phones we already know they come with email, calculators, personal organizers, GPS etc).

Phil, Opt, fellow PSW…

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Vacation Proofing Your Portfolio

by OptionSage - July 25th, 2008 6:43 am

NEW INFORMATION = TAKE ACTION

Save it.  Post-it.  Record it.  Use it.

When driving a car and some object appears on the road ahead do you usually run right over it or do your best to avoid it?  Don’t we all take action in real-life based on the new information we receive that changes the old paradigm?  Take the first two guys in this video:  Who would you rather be, the first or the second guy?  While the second gentleman reacts and looks ridiculous in so doing, he’s the guy that is more likely to survive when real disaster hits because he’s reacting to new information.  In fact he doesn’t even know what’s making everyone else react, he just knows that when 99% are moving one way in panic, it’s best not to fight the crowd or he will be trampled.  It’s no different in the market.  Pride, ego and old theses have no place when new information directly contradicts an existing trade.

When the market is up, we use DIA puts and calls to "react" to quick changes in the market while we wait for better information before making more permanent changes in our positions.  This gave us the benefit of the quick reaction of gentleman #2, the one who went unquestioningly with the crowd, while also giving us the "wisdom" of gentleman #1, who was confident (or oblivious) enough to soldier onward, despite the fact that the world seemed briefly to be against him.

When new information does arrive, one of the first things I look to do is minimize risk - hedging the existing position.  The next step for me is to become more aggressive in reacting to the new information and shifting the bias of the trade in the opposite direction.  In this article, I will outline our basic strategy for protecting your portfolio from a major dip, which can then be used to adjust your risk profile, based on changes in outlook arising from new information. 

The strategy outlined can be applied also when you know that you will be unable to monitor your positions.  Many of you will likely be taking vacations this summer and, with them, a break from actively monitoring your positions.  With that in mind, it’s always prudent to protect your positions from the “just in case” events that can derail your positions in a flash when you are not attending to them.  Those “just in case” events are a…

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The Trading Virus

by OptionSage - July 23rd, 2008 10:22 am

Those successful shorter-term traders succeed not because they are results-oriented but because they are process-oriented.  And those victims who cure themselves do so precisely because they transition from the trap of attempting to time the market perfectly all the time to creating a process that succeeds at all times.  You will quickly see at PhilStockWorld that Phil and Optrader are both highly successful traders.  Both use options to take advantage, albeit in slightly different manners.  And that’s the key.  Each has his own approach and process.  They do not focus so much on trying…

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Vampiric!

by OptionSage - July 13th, 2008 11:48 pm

Black Hole:  a region of space in which the gravitational field is so powerful that nothing, not even light, can escape its pull after having fallen past its event horizon. The term "Black Hole" comes from the fact that, at a certain point, even electromagnetic radiation (e.g. visible light) is unable to break away from the attraction of these massive objects. This renders the hole’s interior invisible or, rather, black like the appearance of space itself.

If it ever felt like the market had a black hole, now might be that time!  An inescapable magnetism with vampiric tendencies is exhausting the patience and energy of the most steely and experienced stock market traders.  In the depths of the gloom and amid the contagion of panic, solace and wisdom can often be found in the words of those who have seen it all before, long before any of us had begun to even dabble.  The following quote is from Remiscences of a Stock Operator:

"And right here let me say one thing:  After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this:  It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  You always find lots of early bulls in bull markets and early bears in bear markets.  I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit.  And their experience invariably matched mine – that is, they made no real money out of it.  Men who can both be right and sit tight are uncommon.  I found it one of the hardest things to learn.  But it is only after a stock operator has firmly grasped this that he can make big money."

Having dipped a little toe in the water this week only to find blood-thirsty sharks hiding under the surface, this quote serves the purpose of reminding not just the reader but the author of the imprudence of ignoring market sentiment.  But words tend to be poor descriptors of raw sentiment.  Instead pictures have a habit of conveying the heart of an issue.  And perhaps, this chart of Fannie Mae in freefall suffices to illustrate the current market…

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