Avoiding Margin Calls on Stock

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Each week, Lee will share his predictions on what he anticipates from the bond and S&P markets. [Watch Video]( Avoiding Margin Calls on Stock by [Jon Najarian]( [How I Trade Options] An adverse move in the market may result in another problem for stock investors – margin calls. For example, if you buy 100 shares of a $100 stock on margin, you agree to put up $5,000 while your brokerage puts up the other $5,000 (and charges you interest on that loan). Now, say the stock declines sharply in value and the $5,000 you put up is virtually exhausted. The brokerage firm is going to demand more money to cover the difference, which is known as a margin call. If the money isn’t immediately forthcoming, the brokerage will liquidate your position to cover that debit. Keep in mind that, with volatile shares such as Internet stocks, brokerage firms may demand the investor put up a higher percentage – 75 or 80 percent – instead of the usual 50 percent on margin. In the worst-case scenario, a stock is bought on 50 percent margin. Then, the share price declines dramatically, resulting in a margin call to cover the shortfall – plus the brokerage firm raises the percentage that an investor must put up to 75 or 80 percent. You’d then be in the unenviable position of putting up more money to hold onto a losing position. That, in and of itself, is a good reason to own options instead of stocks. Granted, options may be brand new territory for many investors. But people “invest” in options all the time. Consider taking an “option to buy” in real estate, a common practice among many developers to secure the rights to several parcels of property before buying. Or, consider insurance which, in its simplest form, is nothing more than a “put” option to protect you from downside risk – in this case decline in your property value because of damage or destruction. In fact, the easiest way to understand how options work is to look at puts. If you buy a put, you’re acquiring the right to sell a stock at a given price within a certain timeframe. Let’s say a stock that you hold in your portfolio is trading at $50 a share and you’re concerned it may decline in value. To protect yourself, you can buy a put to sell the stock at, say, $45 a share. So if it declines to below your target, you can exercise your right to sell at $45. (Remember the theory behind all trading is to sell at the highest possible price and to buy at the lowest). If the price doesn’t go down, your stock portfolio will register the gain. And all you’d lose on the options trade is the premium that you paid for the put. For that reason, options trading is analogous to purchasing insurance. Think about it. Would you drive out of a dealership with a new vehicle without insurance? Of course not. However, not every insurance policy is the same. The larger the deductible, the smaller the premium that must be paid. And we all know, it costs more to insure a Mercedes than to insure a Hyundai. But let’s assume that you have a $500 deductible on your Hyundai, and the car is totaled in an accident. You only have to pay the first $500 in the loss, the rest is paid for by the insurance company. In options terminology, you paid $500 (the deductible) to guard against the entire cost being a loss. When catastrophe strikes, the party that sold the put – in this case the insurance company – pays the difference. If you drive for the life of your car without an accident, you’ve “lost” the premium you paid for the insurance policy. But, you had the protection of that insurance policy just in case. Legal requirements aside, no one would buy a car or a house without insurance. But people buy stock all of the time without downside protection. To most of us in the industry, this is as unfathomable as owning a $400K home without an insurance policy. Say you hold Microsoft, a blue-chip stock if ever there was one. This champion seems to only go up, so why waste money on buying protection that will doubtless go unneeded. On the other hand, let’s say you started to feel like it was time to protect some of the thousands of shares you own that cost $5 a share but that are now trading at $90 a share. You’re willing to pay a $5 “deductible” in case of a loss, so you buy the $85 put. That put may be exercised any time during the life of that option. But obviously, you would only want to exercise the right to sell Microsoft at $85 a share when it’s trading below that price. And even if Microsoft should trade to as low as $50 or $60 a share, by exercising that put, you may sell at the $85 strike price – and the party that sold you the $85 put must buy from you at that price. What happens if Microsoft goes from $90 to $110 a share? Obviously, you’re not going to exercise that option to sell at $85. All you’ve lost is the premium you paid for that put option, which expires worthless. But that option gave you the peace of mind to hold Microsoft through $100 a share, knowing that you were covered if the market suddenly made an adverse move. There is no way you can say that you “wasted” your money buying that put, any more than you could say you “wasted” money on your homeowner’s policy because your house didn’t burn down! Options are more than just an insurance policy, though. They are also effective means to trade the market, regardless of whether you have a small or large stock portfolio. Options can bring balance into your holdings, helping you to guard against risk and minimize exposure – and also to reap returns based on how you think a particular stock will perform. Stated simply, you can use options to capitalize on certain market moves – buying calls when you’re bullish and puts when you’re bearish. Options also provide leverage, increasing the buying power of your investment capital. And they offer greater diversity in your holdings. For example, say you want to buy 1,000 shares of Apple, which is trading at $95 a share. To make the purchase outright, you’d need $95,000. Fully margined, you would need to put up $47,500. (Investors can buy stock on 50 percent margin, but you still must pay interest to the brokerage on the amount of money loaned to make the purchase, as well as commissions. These fees are paid regardless of whether your investment appreciates or declines in value.) [Read More]( [www.tradewins.com]( [Facebook]( [Twitter]( [LinkedIn]( [Youtube]( [Better Business Bureau]( © Copyright 2020 [TradeWins.com](. All rights reserved. TradeWins Publishing, 22C New Leicester Hwy, #117, Asheville, NC 28806 Email: support@iss-trading.com | Phone: 888-233-1431 | Fax: 888-258-4938 PLEASE READ: Auto-trading, or any broker or advisor-directed type of trading, is not supported or endorsed by TradeWins. 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