Basics of Financial Investing – Part 2

Options: Puts and Calls

Normally someone who wishes to buy or sell securities will simply enter an order (market or limit) to do so. Put and call options, in contrast, are generally thought of as either stand-alone investment instruments to buy, hold, and sell, or as instruments to be used as part of a more complex position involving a combination of securities. And yet, options also provide an interesting and useful vehicle for both buying and selling stock. Utilizing options as an indirect means of trading shares of the underlying stock involves making a trade-off between the certainty of having the trade implemented and the possibility of achieving a better price on the transaction. If you use options as a trading vehicle, you give up a little bit of certainty in exchange for the prospect of obtaining a better price. Before we can examine the specifics of how this is done, we need to understand the basics of options.

First, let’s explore terminology. Some of the relevant option terms are defined below. Additional terminology will be introduced as the need arises.

Most option contracts provide a vehicle for the purchase or sale of stock (as opposed to some other asset). The standard stock option contract is written for 100 shares. Options can, however, be written on other types of assets such as bonds or even futures contracts.

Puts and Calls Defined

Call: A contract that provides the owner with the right, but not the obligation, to purchase a pre-specified amount of an asset (e.g., stock) at a pre-specified price (strike price) over a pre-specified time period.

Put: A contract that provides the owner with the right but not the obligation to sell a pre-specified amount of an asset at a pre-specified price over a pre-specified time period.

An in-the-money call is one where the strike price is below the stock price.

An in-the-money put is one where the strike price is above the stock price.

An at-the-money put or call is one where the stock price equals the strike price.

An out-of-the-money put (call) is one where the strike price is above (below) the stock price.

The seller or writer of the option contract (call or put) is paid a price for entering into the contract and thereby standing ready either to sell (call) or buy (put) the asset if the option is exercised.

Options investors pay for the privilege of being able to decide later whether or not to exercise the rights provided by the option contract.

When you own an option, you are the one who decides whether or not to exercise it. The option writer or seller, in contrast, must stand ready to perform under the contract when and if you choose to exercise. This ownership right of the option-holder has an important impact on the option’s value. We shall now explore the topic of option valuation.

Option values (prices) can be decomposed into two components. The first component is the intrinsic value. That intrinsic value is the value that would be derived from the option if it was immediately exercised. In the case of a put, the intrinsic value is equal to the strike price less the stock price, as long as the difference is positive. If the difference is negative, the intrinsic value is automatically assigned a value of zero. As an example, a put with a strike of 30 and a stock price of 27 would have an intrinsic value of 3 (30 – 27 = 3).

Those 3 points of intrinsic value reflect how much the stock’s current market price exceeds the amount that the put option writer would be required to pay for the stock. If the put was immediately exercised, it would cause the buyer (put writer) to pay the seller (put owner) 3 more points per share than the stock sells for in the marketplace. The put option with a strike of 30 allows the holder of the option to sell stock to the put writer at a price of 30 regardless of the current market price. When the market price is 27, the put holder owns a contract giving him or her the right to sell the stock for 3 points more than the price that is currently available in the market. But of course, the stock price is very likely to be something other than 27 as the put approaches expiration.

Clearly, any option should be worth at least as much as its intrinsic value. An option will, however, almost always trade in the marketplace for more than its intrinsic value. The above intrinsic value price that usually obtains in the market is due to the attractive features that the option provides. These features include: (1) the ability to wait until just before the option expires before having to decide whether or not to exercise it, and (2) the ability to control a lot of stock with a small sum of money.

In the current example, if the put is sold for 5, that would price it at 2 points above its intrinsic value of 3. Since the stock itself sells for 27, the put sells for less than a fifth as much as the stock. Thus a speculator who wanted to place a large bet on the stock could use options to control more than five times as many shares with the same sum of money as with an outright stock transaction. Viewed another way, options provide what amounts to a high degree of leverage.

The difference between the market price of a put option and its intrinsic value (in the current example: 5 – 3 = 2) is called the option’s time value. This time value largely reflects the premium price that the option-holder must pay for the right to wait until the option’s expiration date to decide whether to exercise or abandon the option. If the underlying stock’s price moves in a favorable direction (up if a call, down if a put), the option’s intrinsic value will rise (assuming it is in-the-money), which will almost always cause the option’s market price to increase. If the stock’s price does not move in a favorable direction, the option’s market value will decline. The option may eventually become worthless. Your losses are, however, limited to what you paid for the option.

As an option owner, you are allowed to wait until just before the option expires before you must decide what to do. That way you can wait until the last minute to see if the underlying stock’s price is above or below the strike price before having to decide whether or not to exercise your option. The longer the option has to run, the more time the underlying asset has to move in a favorable direction and thus the more valuable is this right to sell it (put) or acquire it (call) at a fixed price. In the above example, if you bought the put with a strike of 30 for a price of 5 and the stock fell from 27 to 20, your option’s intrinsic value would rise from 3 (30 – 27 = 3) to 10 (30 – 20 = 10). Clearly, you would want to derive value from this option.

One way to extract that value would be to exercise the option (rather than allow it to expire unexercised). That is, you could use the put to sell shares having a market value of 20 for the put’s strike price of 30. If you did not already own the shares, you could first buy them in the market at 20 per share and then use your put to sell the shares at 30. That would yield a profit of 10 per share (less commissions). A similar way to derive value from your in-the-money put is to sell it. It should sell for at least its intrinsic value or 10 per share. You should always be able to realize value from an in-the-money option by either exercising or selling it, just as long as you do one or the other before it expires.

Intrinsic and Time Values of Options

Intrinsic value is the financial benefit that could be derived from the option if it was immediately exercised.

For a call, the intrinsic value equals the stock price minus the strike price, if positive.

For a put, the intrinsic value equals the strike price minus the stock price, if positive.

If the difference is negative, the intrinsic value equals zero by definition. Time value for an option equals the amount that the option’s market price exceeds its intrinsic value.

Out-of-the-money options, in contrast, are not advantageous to exercise. They lose most and eventually all of their value as they approach expiration. If, for example, the stock price rose to 35 before the put (with a strike of 30) expired, you would be best off letting the option expire unexercised. You would rather sell your shares in the open market at 35 than to put them to the writer at 30. The right to sell a stock at 30 when the market price is 35 is of little or no value, particularly if the option is about to expire.

As an option approaches its expiration date, its price tends to move toward its intrinsic value. In other words, as the time left before an option expires gets short, its time value tends to disappear. In the above example of a put with a strike of 30, if the stock’s price did fall to 20, you could sell the put option for at least its intrinsic value of 10 (30 – 20 = 10). Since you paid 5 for the option, you would thereby have doubled your money. On the other hand, if the stock’s price rose to 30 or more, the option’s intrinsic value would fall to zero. If the stock price was above 30 on the day the option expired, the option would expire worthless. In this latter case, the most you could lose is what you paid for the option.

Option market values depend upon a number of factors including the length of the option’s remaining life, its strike price, the underlying stock’s price, risk level, and dividend rate as well as the market rate of interest (see Table 2.1).

Options almost always trade for at least their intrinsic value

Options almost always sell for more than their intrinsic values. To understand why this is so, consider the alternative possibility. Suppose a call option (giving you the right to buy the stock at a pre-specified price over a pre-specified time period) could be bought for less than its intrinsic value. One could then buy the call, exercise it, and then sell the stock, thereby acquired for its market price. The result would be an instant profit. To illustrate this point, consider the case of a call having a strike of 30 when the underlying stock sells in the marketplace for 35. This call has an intrinsic value of 5 (35 – 30 = 5). Suppose you could buy the call for 3, which is 2 points below its intrinsic value. You could buy and immediately exercise it, thereby acquiring the stock for 30. Your total cost for the stock would be 33 per share. You would pay 3 for the call and 30 to exercise it (3 + 30 = 33). You could simultaneously sell that stock for its market price of 35, thereby capturing a profit of 2 points (less commissions) per share (35 – 33 = 2). You could profitably implement this set of trades over and over again. Just as long as the call option having a strike of 30 traded at 3 and the stock at 35, you could pocket a profit of 2 points per share (less commissions).

TABLE 2.1. Factors Affecting an Option’s Value

Call Put
Factor Direction of Impact Direction of Impact
Strike Price - +
Stock Price + -
Volatility (Risk) of Underlying Stock + +
Remaining Life of Option + +
Market Rate of Interest - +
Dividend Rate on the Underlying Stock - +

The opportunity to earn meaningful arbitrage profits very rarely occurs in the marketplace. When such opportunities do arise, arbitragers quickly rush into the marketplace in order to exploit them. Their arbitrage trading drives the prices back in line with the options’ intrinsic value levels. As long as the option traded for less than its intrinsic value, arbitragers would buy the option. This buying activity would tend to bid up the option’s market price. As the option’s price rose, the gap between the option’s market price and its intrinsic value would narrow. These same arbitragers would simultaneously sell the underlying stock, thereby tending to depress its price. As the underlying stock’s price fell, that decline would also have the effect of reducing the call option’s intrinsic value. Sooner or later the option’s market price would no longer be below its intrinsic value. Accordingly, the trades of the arbitragers would tend to bid up the option’s price while tending to push the stock’s price down. Thus the actions of arbitragers should eliminate any arbitrage opportunities that do appear. The process should occur quickly as arbitragers scramble to take advantage of the mispricing before it disappears.

That is why options almost always trade for at least their intrinsic values. Usually they trade for more than their intrinsic value if their expiration is not imminent. Accordingly, you can almost always count on receiving (paying) at least the option’s intrinsic value when you sell (buy).

Put options may be used to buy stocks

Suppose you have identified a stock that you would like to purchase. Further suppose that you have no reason to expect that the stock’s price will move up dramatically in the near term. You could simply buy the stock on the market for the current market price. But you might consider another approach to acquiring the stock. You could write (sell) an in-the-money put (stock price above the put’s strike price) on the stock that you want to acquire. If the put is exercised, you will end up purchasing the stock from the person who owns the put. Moreover, you will pay a lower overall price (strike price on the put less what you received for writing the put) on it than if you had initially bought the stock rather than written the put. If the put that you wrote is not exercised, you will still be paid for having written it. Once the put expires, you will have no further obligation to the put’s owner.

Recall that a put gives the owner the right but not the obligation to sell the pre-specified stock at a pre-specified (strike) price over a pre-specified time period. The writer of a put takes the other side of the contract. If called upon by the put owner, the put writer is obligated to purchase the stock under the pre-specified terms of the put contract. By writing (selling) such a put, you must stand ready to purchase the specified shares from the put’s owner at any time up to the date of the option’s expiration. If, as the put is approaching expiration, the market price of the stock is appreciably below the put’s strike price (in other words, if the put is in-the-money and just about to expire), the put is almost certain to be exercised. The owner always has an incentive to exercise the put as long as the stock price stays in the range below the put’s strike price. Very rarely will in-the-money puts be allowed to expire unexercised.

Failure to exercise an in-the-money option is like throwing money away. And yet, it can and sometimes (rarely) does happen.

Suppose that, in an effort to buy a stock, you wrote a put that remained in-the-money at expiration but was allowed by its owner to expire unexercised. As a result, the stock that you hoped to acquire by writing the put would not have been sold to you. The option owner’s failure to exercise the put that you wrote is actually to your benefit. Since the stock’s market price is now below the option’s strike price, you would be able to purchase the stock in the open market for less than the put’s strike price. But the strike price is the price that you would have had to pay if the put had been exercised. If you still want to acquire the stock, you should buy it at the market price or write another in-the-money put (and wait for it to be exercised).

Option holders have an incentive to wait until near expiration before deciding whether or not to exercise their options. As a result, the vast majority of option exercises occur in the last few days before the option is set to expire.

What are the advantages of using a put sale (rather than an outright purchase of the underlying stock) to implement a stock purchase? First, you are paid a sum of money (the put price less commission) up front for writing the put. Second, you delay paying the full amount of the stock’s purchase price until the put is exercised. Third, and most important, your net cost, if you buy the shares, is less (by the amount of the put’s time value) than what you would have paid with a direct stock purchase.

As a seller (or writer) of an option, you are paid a price that includes both the intrinsic and the time value. The intrinsic value plus the strike price equals the current stock price, the amount you would pay to buy the stock at its current level. The time value is the bonus that you, the writer, receive for using a put sale to implement a stock purchase. You write the put because you want to buy the stock. In the above example, you sell a put for 5, which, if exercised, requires that you purchase the stock for 30. If you bought the stock today, you would pay 27. But with the put sale you are paid 5 today and must pay 30 for the stock if and when the put is exercised. So if the put is exercised, thereby causing you to buy the stock, your net cost is 25 (30 #5 ¼25) rather than the current market price of 27. Furthermore, you save some financing costs by not paying the stock’s full purchase price until the option is exercised.

If, for example, the put has six months to run, you will not be called upon to pay the put’s strike price (to buy the stock) for another six months. Finally, if you later decide you don’t want to purchase the stock, you can extricate yourself from the obligation by buying an equivalent put to offset your short position. As long as you buy it back before the put that you wrote is exercised, your obligation will be extinguished. You don’t need to buy back the same put that you sold, you just need to purchase one that is equivalent to (same strike price and expiration date) the one that you sold. This process of buying an offsetting option (either put or call) is called covering your option position.

This strategy of trying to buy stock by writing in-the-money puts is not devoid of risk. The strategy is designed to implement a purchase on the selected stock. That purchase takes place only if the put is exercised. In our example, the stock could rise above 30 during the time that the put, having a strike of 30, is still outstanding and unexercised (that is before the put expires). If around the date of the put’s expiration, the underlying stock’s price is above the option’s strike price, the put-holder will not exercise the option and therefore you will not be required to buy the stock. Your objective in writing the in-the-money put was to purchase the underlying stock. But the stock’s price rises so high (above the put’s strike price) that the put-holder will not have an incentive to exercise the put that you sold. A rational put-holder will choose not to sell you the stock for the put’s strike price when they can sell it for a higher price in the market.

Remember, the put-holder has the right but not the obligation to buy the stock at the strike price. In this instance, your put-writing strategy has not achieved your basic objective of acquiring the stock. You do, however, earn what amounts to a consolation prize. The money that you were paid for the put sale is yours to keep free and clear. Generally, that is not such a bad outcome. You were paid 5 for agreeing to buy the stock at 30, if asked. You ended up doing nothing because the put that you wrote was not exercised. In other words, you got paid 5 for agreeing to stand ready to do something that, in the end, you were not required to do. Still, if the stock’s price rises to 40, you would probably prefer to have bought it at 27 (the price of the stock when you sold the put) rather than receive the consolation prize of the put-sale proceeds. So if you want to be absolutely sure of purchasing a particular stock, this strategy of writing in-the-money puts is not for you. On the other hand, if you are willing to take a chance that you will not buy the stock, but if that happens, you will be rewarded for trying, you may find this strategy to be of interest.

Call options can also be used to sell stocks

Just as a strategy of writing an in-the-money put option can be used to buy a stock, a similar sort of strategy that utilizes the sale of a call option can be employed when you want to sell a stock that you already own. Rather than writing a put, you would write an in-the-money call. Suppose you own a stock that is now selling for 27. Rather than sell the stock immediately at the current market price of 27, you could write a call with a strike at 25. Such a call might sell for a price of 4. In this case, the call option has an intrinsic value of 2 (27 - 25 = 2) and a time value of 2 (4 - 2 = 2). As long as the stock’s price is trading above 25 when the option expires, the option will be exercised and you will have sold your shares for a total of 29 (25 + 4 = 29). This sum compares with what had been the market price of 27 that was available when you wrote the call.

Again, this strategy has a degree of risk. If the stock’s price is below 25 at option expiration, the call will not be exercised and you will not sell your shares via the call that you wrote. But you still retain the proceeds (4) from the call sale. At that point you can write another call and wait to see if it is exercised, or you can just sell the shares at the currently available market price. Unless the stock has fallen more than two points below 25, you will still come out ahead (compared to having sold the shares directly). On the other hand, if the stock’s price falls dramatically, the call will not be exercised and you will wish that you had sold the stock at a higher price when you could.

Writing an in-the-money call is a relatively conservative approach to using options as a stock-selling vehicle. Writing an out-of-the-money call represents a more aggressive strategy. Suppose, for example, you wrote a call with a strike of 30 for a market price of 1. If the stock rose from 27 to or above 30 before the call expired and stayed in that range at the call’s expiration, the call that you wrote would be exercised. In this case, you would have to deliver your stock to the call-holder for the strike price of 30. As a result, you would derive a total of 31 per share (30 + 1 = 31) from the sale of your position. If, however, the stock’s price stayed below 30, you would still keep the 1 that you derived from the call sale. But the call would not be exercised and thus you would not have sold your stock. On the other hand, once this particular call expired, you could write another call option. If the stock stayed in the high 20s, you might receive another 1 point for the sale of a second call. You could continue to write calls on your position until one of the calls you wrote was exercised. That would be like earning a second dividend of a dollar a share on your position.

One further consideration for both call and put writers concerns the matter of collateral. When you write an option, you are obligating yourself to perform under the terms of the option contract. If you write a call against stock that you already own, the shares that you may need to deliver to the option-holder already sit in your account. The broker and brokerage firm who handled your call sale will be comfortable with the arrangement. On the other hand, if you write a put, you have obligated yourself to purchase the shares if the put is exercised. The brokerage firm handling the trade will demand that you either have enough cash or borrowing power (see margin) derived from other unencumbered assets in your brokerage account to cover the cost of buying this stock if the put option is exercised. Similar rules apply if you write a call without owning the underlying shares (naked writing).

Neither buying stock by writing puts nor selling stock by writing calls is without risk. In both instances, a large adverse move in the underlying stocks’ prices can render the strategy suboptimal. Still, using options as a vehicle for buying and selling stocks is a strategy worth a second look.

Sources of Credit

Investors often use borrowed funds to help finance the acquisition of the securities in their investment portfolio. Using other people’s (borrowed) money to generate profits for yourself can be advantageous. Indeed, efficient debt management is an important aspect of effective investing. If you can earn a higher rate of return on your investments than you pay in interest to borrow the funds, your use of leverage will be profitable. Similarly, if you can use your investments as collateral to facilitate borrowing needed funds more cheaply than if you borrowed the same sum in another way, you are thereby reducing your cost of debt service. Both results are likely to be to your financial advantage. Using the market value of your portfolio as collateral for a loan from your broker is called margin borrowing. You may utilize a margin loan in order to finance additional investments or other types of spending, or to pay down other debts. While margin borrowing has many advantages, it also involves some noteworthy risks. Leverage is a double-edged sword. Let’s now explore its advantages, risks, and, most important, how to manage those risks.

Margin debt is almost always cheaper (a lower interest rate) than credit card debt. Pay off credit card debt with funds derived from a margin loan. Then be sure to pay off your credit card balance by each month’s due date.

One of the benefits of having an investment portfolio is the ease with which you can use its market value as collateral for a margin loan. Margin loans do not require a credit check, or any specific repayment plan, and can be obtained on very short notice. Margin loans also do not incur prepayment penalties, or loan origination fees, and the interest rate charged is generally quite attractive. For those who have the collateral to borrow against, margin loans are a more advantageous source of credit than almost all of the alternatives.

Suppose, for example, that your investment portfolio has a market value of $10,000 and no debt against it. You could borrow up to 50 percent of the portfolio’s value ($5,000) and use the borrowed funds for any legitimate purpose. The funds thereby obtained could be used to pay bills, pay down other debts, or just to spend on whatever. If the borrowed money is used to finance additional investing, the purchased securities would have the effect of increasing the market value of your portfolio, thereby increasing your borrowing capacity. Indeed, you could borrow up to a total of $10,000 on a portfolio with an initial market value of $10,000, just as long as all of the borrowed funds were used to buy more securities. That is, $10,000 of equity can support a $20,000 portfolio with $10,000 of margin debt. Thus, if you started with an unencumbered $10,000 portfolio of stocks, you could buy up to another $10,000 of stock using the first $10,000 as collateral. As a result you would have a $20,000 portfolio with a $10,000 lien against it.

To qualify as collateral for a margin loan, the securities must meet certain standards. Typically, to be marginable, stocks must trade above some minimum price per share, like $5, and either be listed on an exchange or on the NASDAQ’s national list.

The interest rate that brokerage firms charge on their margin loans is generally tied to a nationally established interest rate that is referred to as the broker call loan rate. This broker call loan rate is the interest rate brokerage firms must pay for the bank loans that they obtain in order to finance their own margin lending. In other words, the brokerage firms borrow from banks in bulk at the broker call loan rate and then lend to their margin loan clients individually. Their cost of funds, the call loan rate, determines how much they charge their clients for margin loans. This call loan rate is usually set a bit above or below the prime rate (the rate that banks charge their high-quality, low-risk customers). Depending upon the brokerage firm and the size of the loan, the rate charged on a margin loan may be as little as 0.5 percent to as much as 2.5 percent above the broker call loan rate. If, for example, the broker call loan rate was 5.0 percent, the margin loan rate charged individual customers would range from 5.5 to 7.5 percent. Most credit card rates are in the range of 1 to 2 percent a month or 12 to 24 percent per year. Clearly, substituting margin borrowing for credit card debt will save the borrower a substantial amount in interest charges. Moreover, to the extent that the money borrowed is used to finance investments, the interest charged can be utilized as an itemized deduction. This investment interest deduction may, however, be employed only to offset the tax liability on the taxpayer’s dividend or interest income. Interest paid on credit card, personal, or auto loans, in contrast, is not deductible.

Margin debt is usually a more attractive way to borrow than other types of personal borrowing, such as auto or personal loans. Use it as a substitute source of credit when it is available.

Personal and auto loan rates, while rarely as expensive as credit card rates, are generally above the interest rates charged on margin loans. If you have sufficient collateral to do so, you are usually better off using the borrowing power of your investment portfolio to finance your automobile purchases with a margin loan than financing your car with a standard automobile loan.

Automobile companies do sometimes offer very attractive loan rates as a sales incentive (0% or 1% loans). Such deals require the auto company to subsidize the lender. Thus, the auto shopper may well be able to negotiate a better price on the car purchase by forgoing the cheap credit and financing the purchase elsewhere. One who has sufficient borrowing power to finance an auto purchase or to provide for other credit needs from margin borrowing should at least consider doing so if, as is usually the case, the interest rate is lower.

Margin borrowing power provides the investor/consumer with a useful backup line of credit.

Financial planners and investment counselors recommend that individuals hold a cash reserve for unexpected contingencies. Typically, a reserve equal to about six months of the individual’s yearly income is suggested. This reserve would usually be held in a form that is able to be converted into spendable cash almost immediately (savings account, money market accounts, very-short-term CDs, etc.). Such a reserve is then available if needed, to cover unexpected/ emergency expenses such as those arising from an operation, job layoff, auto accident, or wedding, for example. The ability to borrow an equivalent sum via a margin loan on your investment portfolio constitutes an effective substitute for an actual cash reserve. The availability of this backup line of credit thereby frees up reserve funds that would otherwise sit in a high-liquidity, low-yield account. The liberated funds can now either be invested in longer-term investments with higher potential returns or be used to pay down high cost debt.

Margin debt is not usually an effective substitute for fixed-rate mortgage debt, but it may be a reasonable alternative to a home equity loan.

Very few investors could borrow enough through their margin account to finance their home. Those few who could probably shouldn’t do so. Similarly, using margin debt to pay down one’s mortgage balance is rarely a good idea, even when the current margin loan rates are lower than the currently available mortgage loan rate. A mortgage loan can be and usually is structured to have a fixed interest rate. This fixed rate coupled with the amortization of principal results in a stable monthly payment amount. The borrower, therefore, knows that the mortgage payment will be the same amount each month. Such certainty is important for family budgeting purposes. An additional advantage to such a fixed-rate mortgage is that it can be refinanced at a lower fixed rate if mortgage rates fall in the marketplace. Margin loan rates, in contrast, are reset periodically as market interest rates change. That degree of interest rate uncertainty is generally not problematic for short-term, small-balance borrowings. For long-term, high-balance borrowing (such as with a mortgage), however, the risk of an adverse interest rate move is a much greater danger. Suppose, for example, you are paying $1,500 a month in interest (a mortgage payment of $2,000 including $1,500 in interest) to finance your home. An interest rate spike (for example, rates might rise from 6 to 10 percent in a short time period) could cause that monthly interest payment to rise to $2,500 ($3,000 total). An extra $1,000 a month in interest costs would blow a hole in many (most) family budgets.

While financing your home purchase with a traditional fixed-rate mortgage is usually preferable to other forms of financing, margin debt may still be a useful supplement in particular situations. Specifically, you might wish to use money borrowed on margin to facilitate taking out a lower-balance mortgage loan in at least two situations. Generally, the interest rate charged on a mortgage loan is often lower when the borrower makes a sufficiently large down payment. A larger down payment makes the loan safer for the lender. Thus, a mortgage loan with an initial balance equal to 80 percent of the property’s appraised value may be charged a higher mortgage interest rate than one equal to 75 percent.

Similarly, the borrower may be required to purchase mortgage insurance when the amount borrowed is above a certain threshold percentage of the property’s market value and not otherwise. Mortgage insurance is put in place to protect the lender in the event that the borrower defaults. If the ratio of the collateral value of the property to the mortgage balance is large enough, the lender will not require you to purchase mortgage insurance. The high market value of the collateral provides the lender with sufficient protection. In the unlikely event that the lender must foreclose on the property, its sale should bring more than enough to pay off the outstanding mortgage balance. Thus, if the collateral-to-loan-balance ratio is high enough, mortgage insurance is not needed. Since it involves an extra cost and provides little or no benefit to the buyer, you should avoid buying mortgage insurance if you can do so.

Accordingly, you may want to stretch your finances a bit in order to obtain a large enough down payment to avoid the cost of mortgage insurance and/or to qualify for a lower interest rate on your mortgage loan. In such circumstances, a prudent amount of margin borrowing may appropriately be used to help with the down payment.

While not an attractive substitute for a standard fixed-rate mortgage, margin loans are competitive with variable-rate home equity loans. Both margin and home equity loans offer flexibility. The interest payments on both may be tax deductible. Moreover, the interest rates charged tend to be relatively low for both types of loans. One major advantage of margin borrowing is the absence of any fees or other costs for setting up the credit facility. Home equity lines of credit, in contrast, typically require a title search. Title searches, which involve lawyers and title insurance, tend to be rather costly. Various other loan fees may also be incurred with a home equity loan. These fees can add up to a significant sum. So, if you don’t already have a home equity credit line established, the choice between using a margin loan or a home equity loan may well favor the margin loan.

Limit initial margin borrowing to no more than 30 percent of your portfolio’s market value.

One major drawback to margin borrowing (and not to most other types of borrowing) is the risk of receiving a call on the loan. A call on a loan is a demand by the lender for immediate repayment. The vast majority of standard loans have a pre-specified term and loan repayment schedule. As long as the borrower makes the payments specified in the repayment schedule, the outstanding loan balance is extremely unlikely to be called prior to its due date.

Margin loans, in contrast, do not have a pre-specified time for repayment. They are extended for, what could be, an unlimited period. As long as the collateral is adequate, the loan is allowed to remain outstanding. The borrower is not required to adhere to any kind of specific payment schedule. Indeed, the monthly interest charges can simply be added to the principal as long as the collateral is large enough to support the loan. Margin loans are, however, always at risk of being called. Such loans are extended on collateral whose value will change over time. The securities that are used to collateralize the margin loan are continually trading at prices that reflect the changing interplay of supply and demand. Thus the securities collateralize the loan are continually fluctuating in market values. The lender is fully protected only to the extent that the collateral value of the portfolio on which the loan is extended exceeds the amount borrowed.

Under current (2006) regulations (set by the Federal Reserve and not changed in many years), a margin loan’s outstanding balance cannot initially exceed 50 percent of the market value of the stocks in the account on which it is based. Different percentages apply to bonds. Once a margin account’s balance reaches this 50 percent threshold, no more can be borrowed on that collateral. An account with $50,000 in total collateral value could support up to $25,000 in initial borrowing, thereby leaving another $25,000 in equity. Your equity position is the residual left after the loan balance is subtracted from the account’s total market value.

For a margin loan to remain secure, the collateral must maintain sufficient value so that the amount of the debt remains substantially less than the collateral’s value. Security prices fluctuate, sometimes by large amounts. A margin loan may, when initially extended, be highly secure. The collateral value of the borrower’s portfolio may be well above the required minimum. If, however, security prices fall sufficiently, that same account’s collateral value may quickly deteriorate to a position where the equity in the account is at risk of being too small to support the margin loan. Margin lenders want to avoid finding themselves in the position of having extended a loan whose outstanding balance exceeds (or even gets close to exceeding) the value of the collateral pledged to support the loan (equity value in this margin account that is close to or below zero). Indeed, lenders always want to see a safe cushion of equity in the accounts that they lend to. Margin calls are designed to provide the lenders with a vehicle that they can use to avoid becoming under secured. Such margin calls provide a type of early warning for outstanding margin loans that have come to be at risk. When triggered, a margin call provides a signal that the account may be approaching a deficit position. The borrower who receives such a margin call is required to take corrective action.

Consider as an example a margin account that, when established, has stocks in it with an initial market value of $50,000 and $25,000 in margin borrowing. This account would start out with an equity value of $25,000 ($50,000 - $25,000 = $25,000). At these levels, the account would be financed by 50 percent debt and 50 percent equity. If the market value of the securities in the account fell to $40,000 (a 20% decline in the account’s market value), the borrower would still owe $25,000, but much of the account’s collateral value would have disappeared. The decline in the value of the portfolio would be matched dollar-for-dollar by an equivalent decline in the account’s equity position. At the $40,000 value level, the account would be above water by (have an equity value of) $15,000 ($40,000 - $25,000 = $15,000). At $15,000, the equity in the account corresponds to 37.5 percent ($15,000 / $40,000 =.375) of the accounts’ total market value. Most margin lenders issue a margin call (a house call) when the percentage of equity drops below 35 percent of the account value. Some wait until the equity percentage falls to 30 percent; the Federal Reserve requires a margin call (a Fed call) if the equity percentage declines below 25 percent. The account with 37.5 percent equity is just a bit away from the point where the margin borrower would be likely to receive a margin call (house call). Should the portfolio value drop another $1,600, the point for a margin call would be reached ($13,400 / $38,400 = 34.9%). Once the margin call is issued, the brokerage firm would demand that the investor restore the account’s equity position to at least the 35 percent level (assuming that is the firm’s threshold). The investor could have effected the required restoration in any of three ways:

Sources of Credit

a. Pay off some of the loan balance with cash.

b. Add margin able securities to the account in order to increase its collateral value.

c. Sell securities from the account and apply the proceeds to reducing the loan balance.

Most margin borrowers cannot easily do either “a” or “b”, at least not within the few days that their broker gives them to implement their restructuring. Investors who receive margin calls are typically tapped out of loose cash and have already placed all of their marginable securities into their investment accounts. This leaves them with option “c”. The only available way most investors have for dealing with a margin call is to sell at least part of their holdings in order thereby to pay down their margin debt.

Receiving a margin call is always an unpleasant experience. Having to sell securities to meet a margin call is likely to be particularly painful. Such calls almost always arrive at what is a poor time to have to sell securities. Typically the market is well below its recent highs, and most or all of the investor’s securities are selling at depressed levels. Margin calls usually force investors to sell shares that they purchased at high prices when the market was booming. When the margin call is issued, the investor almost always must sell securities at much lower price levels, perhaps at or near a market bottom.

And, the required amount of selling is likely to be substantial. Selling to meet a margin call has the effect of reducing the total value (and thus the collateral value) of the portfolio. Accordingly, a substantial amount of selling is needed to restructure the account so that it will be in line with the required margin regulations.

To illustrate how a margin call can damage an investment portfolio, consider the following hypothetical case: Suppose, an account started out with $40,000 in securities and a $20,000 margin loan. What is the result if that account suffers a rapid 30 percent decline in market value? The account’s total value would fall to $28,000. Its equity value would have fallen to $8,000 ($28,000 - $20,000 = $8,000). At that level, only 32.5 percent (8/28ths) of the account’s value would be in the form of equity. To restore the account to a 35 percent equity position would require the sale of about $5,000 of stock. A sale of such a limited amount of stock would leave the account very vulnerable to further margin calls. If market values continue to fall, more margin calls would be likely. A sale of $12,000 worth of stock would be needed to restore the equity position to 50 percent (and thereby have some degree of protection against a further margin call). Selling $12,000 worth of securities would reduce the portfolio’s value from $28,000 to $16,000 and margin debt from $20,000 to $8,000. Such a sale would reduce the value of the portfolio by over 40 percent. Having to sell this amount of stock in a depressed market is sure to be painful for the investor. Recall that the account began with $40,000 of securities and $20,000 in equity. Thus at $16,000 with $8,000 of equity, the account has lost 60 percent of its initial value.

Suppose the market recovers such that the portfolio’s value rises by 30 percent, the same percentage that it fell. After meeting the margin call, the investor who started with a $40,000 portfolio has $16,000 worth of securities left in his or her account. Accordingly, a 30 percent increase in its market value corresponds to less than a $5,000 rise in the portfolio’s value

(0.3 * $11,000 = $4,800). That $5,000 sum is compared to the $12,000 loss when the $40,000 account declined by 30 percent to $28,000. This example illustrates an important point. Having to sell securities in order to satisfy the margin call, in effect, robbed the investor of a chance to recover fully when the market itself came back.

To reduce greatly the risk of a margin call, you should limit initial borrowings to significantly less than the maximum percentage allowed. Restricting initial borrowing to no more than 30 percent of the account value (as opposed to the allowed 50 percent) is a rather conservative approach. With a starting equity of at least 70 percent (1.00 - .30 = .70), a large, and therefore much less likely to occur, decline in portfolio values is needed to reach the point where a margin call is issued (35%). If you started with 50 percent equity, the chance of a margin call would be much greater. If you can avoid a margin call in a major market decline, you will be much better positioned to recover when the market rebounds.

If declines in the market values of the securities in your portfolio cause margin debt to rise to or above 40 percent of your portfolio’s market value, sell securities in order to prevent your debt ratio from rising any higher.

Limiting initial borrowing to 30 percent of your investment account’s value is a useful first step in protecting your investments from the ravages of a major market decline. As a supplemental rule I advise you to take corrective action if and when your margin account’s equity percentage falls to 60 percent (borrowing reaches 40 percent) of the account’s total value. By taking early action, you would have greater flexibility and more time to consider what and how to sell. The sooner you take corrective action, the less painful is the result likely to be. To paraphrase Benjamin Franklin: A sale in time may save nine.

Let’s return to our prior example. The investor (e.g., you) with $20,000 in equity borrows not $20,000, but $9,000, yielding a starting portfolio value of $29,000. At that initial stage, you have about 30 percent borrowed (9/29, %.30). Now suppose that your portfolio suffers a 30 percent decline. That would take the account’s total market value down to about $20,000

(0.7 * $29,000 = $20,300). The equity value would decline to $11,000 ($20,000 - $9,000 = $11,000). You would then have a margin loan position of about 55 percent ($11,000/$20,000 = .55). At this 55 percent level, your account would still be quite some distance away from the point of receiving a margin call. You would not be required to do anything to protect your margin position. You would continue to be well secured. Still, to be on the safe side you might want to reduce the size of your margin loan. A sale of $2,000 worth of the stock would restore the equity percentage to over 60 percent and thus bring the margin borrowing level down to 40 percent of your portfolio’s total market value. Now if the market recovers, you would be in a much better position to recapture your losses than would be the case if a higher percentage had been borrowed and later more needed to be sold in order to meet a margin call. If the market keeps falling, you may have to undertake some additional selling, but a lot less than would be needed if you had borrowed more initially.

These ‘‘30 percent initial’’ and ‘‘40 percent take-action’’ percentages are just guidelines. More experienced risk-tolerant investors may choose to use somewhat higher thresholds. Still, my basic point is valid: Margin borrowing can be risky and becomes most problematic when you are least able to deal with its most dreadful feature: the margin call. To avoid or at least minimize the danger of receiving a margin call, you should place some limits on how much margin borrowing you are willing to undertake and also be prepared to take early action if need be.

Two further points bear mentioning. First, the risk of a substantial value decline in a portfolio that is heavily concentrated in a few securities is much greater than it is for a well-diversified portfolio. If a large percentage of your portfolio is reflected in the value of one or a few stocks, you should be especially cautious about the use of margin. Second, low-priced stocks are particularly risky to rely upon as collateral for a margin loan. Most brokerage firms will not extend margin credit on very-low-priced shares. Many have a per-share threshold of $5. To explore this matter with an example, suppose you have some $7 stock in your margin account. As long as the stock’s price remains above your broker’s $5 threshold, the stock remains marginable. If the $7 stock’s price falls to $6, its contribution to the borrowing power of the account declines, but remains substantial. If, however, the stock’s price declines by a bit more than one more dollar (to below $5), the total value of that stock’s position will be removed from the account’s marginable total. This action could trigger a margin call even though the overall account value is well above the required threshold.

Categories: Finance

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