. . . more than just covered calls . . .
USING MARGIN
THE DATE: November 13, 2006
THE STOCK: AtheroGenics, Inc. AGIX engages in the discovery, development, and commercialization of therapeutics for the treatment of chronic inflammatory diseases.
THE STRATEGY: This is an initial position established using margin. Margin should always be used with caution and restraint. The restraint is due to the increased use of leverage in a margin portfolio. Always understand the risk of using margin! The SysCW suggested guideline is to limit the use of margin to 25% of the account funding or liquidation value, which ever is higher. This is simply a line in the sand based on a verifiable number. Placing a line at less than the 25% maximum is a more conservative approach to this strategy.
THE COMMENTARY: The purpose of this example is to explain the new Initial Margin Position Math Exercise. There are a couple of extra steps. First, a writer needs to enter the Margin Interest Rate. This is the annualized percentage rate that a writer will be charged for the portion of the investment he or she is buying 'on margin'. This percentage varies from broker to broker.
The second percentage, the Stock Margin Rate, is generally going to be 50%, but some firms have 'special' rates for certain stocks. In this case . . . special . . . is not so special after all in that the writer will need to capitalize more of the purchase. Such is the case with today's example.
Take a look at this new form . . . the discussion will continue below:
| Systematic Covered Writing | |||||||||||
| … more than just covered calls! | |||||||||||
| Margin should be used with restraint. The returns will be higher, but remember, you are | |||||||||||
| obligated to pay the margin loan, regardless of the value of the underlying stock! | |||||||||||
| Additional Information | |||||||||||
| Margin Interest Rate | 10.25% | ||||||||||
| Stock Margin Rate | 70% | ||||||||||
| Initial MARGIN Position: The Math Exercise | |||||||||||
| Position: | 300 AGIX With Jan 2008 $12.50 LEAP | ||||||||||
| Stock Symbol | AGIX | Call Symbol | YAYAV | ||||||||
| Stock Purchase Price | $12.960 | Call Sold Price | $7.20 | ||||||||
| Number of Shares | 300 | Call Strike Price | $12.50 | ||||||||
| Trade Entry Date | 13-Nov-06 | Expiration M & Y | 1 | 2008 | |||||||
| Net Cash Generated | $2,149.25 | Net Stock Investment | $3,895.00 | ||||||||
| Net Return if Called | $1,987.25 | Annualized if Called (1) | 43.21% | ||||||||
| Based on a 'cash' position. | |||||||||||
| Cash Required for Trade | $1,745.75 | ||||||||||
| Percentage Recovered w/Option * | 55.18% | ||||||||||
| Days Until Expiration & Expire Date | 431 | 18-Jan-08 | |||||||||
| Total Margin Interest Expense | $150.32 | ||||||||||
| Adjusted Net Cash Generated due to Interest Expense | $1,836.93 | ||||||||||
| Annualized Return Based on Using Margin | 57.06% | ||||||||||
| The Annualized Return using margin is calculated as follows: | |||||||||||
| (1) | The Net Return if Called is reduced by the margin expense. | ||||||||||
| (2) | The amount in (1) is divided by the percentage adjusted investment amount. | ||||||||||
| (3) | The quotient of (2) is divided by the duration in days. | ||||||||||
| (4) | The quotient of (3) is multiplied times 365. | ||||||||||
Other than the two percentage entries, the upper position of the Math Exercise is the same as it always has been. The two key percentages are still calculated the same way, which means without the use of margin. The last three data points are the results of margin, if it is used. The Total Margin Interest Expense is calculated from the execution date through the option expiration date. The other way to say this is, the margin interest is based on the total number of days the position will be in place assuming the stock is assigned on Expiration Friday for the option that was sold.
Keeping in mind the fact that the interest is a cost, it is deducted from the Net Return if Called amount to yield the second new amount. This is the Adjusted Net Cash Generated due to Interest Expense. The amount of back to cash profit must be lowered by the additional cost incurred. That is the bad news. The good news is the amount of capital used to buy the stock is also less. The Exercise does not 'show' this amount, which is simply the Stock Margin Rate percentage times the Net Stock Investment. The Net Stock Investment is based on a cash purchase.
The key to the Math Exercise is to illustrate the effect of using margin for a given position under the assumption that the covered position is not closed or exercised early, and is assigned at expiration. For this example, if the position was established using cash, the potential back to cash gain would be 43.21%. Using margin for exactly the same position, the gain increases to $57.06%
QUESTION: If the difference is only about 14% why would an investor want to use margin in the first place . . . given that it cost 10% or so to borrow the funds. Okay . . . that's a reasonable question . . . there are two answers:
- Realize that the margin return INCLUDES the cost of borrowing a portion of the funds. The additional gain is 'net'.
- In many cases, using margin allows the position to be established in the first place. It is an extra source of revenue that otherwise could not have been established. If the funds were not borrowed, the stock could not be purchased, and if that were the case, the call could not be sold.
This new Math Exercise is attached to this email message. Please feel free to ask questions . . . always!
The Covered Writer
PEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN AGIX STOCK OR ANY OTHER EQUITY. THE INFORMATION IS PROVIDED FOR EDUCATIONAL PURPOSES ONLY. THERE IS NO GUARANTEE THAT SIMILAR TRANSACTIONS CAN BE EXECUTED IN THE FUTURE. INVESTING IN THE STOCK MARKET INVOLVES RISKS, DO SO ONLY WITH A KNOWLEDGE AND UNDERSTANDING OF THE RISKS INVOLVED!
The information provided above is for informational purposes only, and no mention of a particular security constitutes a recommendation to buy, sell, or hold that or any other security, or that any particular security, portfolio of securities, transaction, investment strategy is suitable for any specific person. You further understand that the Covered Writer will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information available on this website may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Always remember that past results are not necessarily indicative of future performance.
These are the terms of use. Why are they here? Because the examples provided are real. The transactions actually took place. The dates are real, the positions are real. Some transactions will have been executed on the day you receive the email. What you are agreeing to, is the fact that in no way is it being suggested that you can, or should, enter a similar position. Why? Because that would be providing investment advice and the Covered Writer is not authorized to do that. There is also no guarantee that similar transactions could be executed at any time in the future. Only licensed brokers are allowed to provide investment advice. Therefore, you are agreeing that the preceding example was provided for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.
Thank you!
SYSTEMATIC COVERED WRITING
Copyright © 2006. All rights reserved.
Revised: 02/05/07