It is tempting to write the word CONTROLLED in before the word 'margin', with the key being control! Ask yourself this question: If one could borrow money at an 8% to 10% annualized rate, would it be wise to do that if they could generate a greater annualized return with the money that was borrowed? What if the annualized return was 12% or what if it were 25%? This is the question that is proposed when an investor considers using, or not using margin in a taxable investment account. Specifically, can more be earned than the expense incurred by borrowing the capital? It really is that simple.
What exactly is margin? In a taxable account, using Systematic Covered Writing process, the covered writer buys stock and sells calls on a variety of positions until the following two events happen. First, all of the funds that were placed in the account are invested in stock positions. Second, all of the premiums that were generated are also invested in stock positions, thus leaving a ZERO cash balance. At this point in time the account or the SysCW portfolio is 'fully invested', which basically means the covered writer has run out of cash to invest.
If the account is approved for margin, a covered writer could, if he or she choose to do so, invest in additional positions. For some positions, its a 'fifty fifty' obligation, meaning the covered writer 'puts up' half the cost of a stock, and the brokerage firm will 'loan funds' to cover the other half. This is commonly referred to as 'using margin'. Literally, if a covered writer funded a taxable account with $25,000, he or she could theoretically purchase $50,000 worth of stock. Actually, they could purchase more than that if they also used the funds generated via the sale of call options to purchase additional positions . . . all on margin.
USING 100% OF THE MARGIN BUYING POWER IS ABSOLUTELY NOT RECOMMENDED . . . AND ANY COVERED WRITER WOULD BE FOOLISH TO USE 100% MARGIN! SYSTEMATIC COVERED WRITING IS, BY NATURE, VERY CONSERVATIVE . . . MARGIN IS SIMPLY A WAY TO INCREASE THE RETURN BY ACCEPTING A SMALL AMOUNT OF RISK!
RULE - SysCW suggests that a covered writer limits the use of margin to 25% of the account funding or 25% of the liquidation value (which ever is greater).
Margin Interest is the interest that is charged for borrowing funds from the brokerage firm. Generally, the margin interest rate varies slightly from firm to firm. The key influences are the amount that is being borrowed and the current Federal Funds Lending Rate. The more the covered writer borrows, the better the deal (within reason). The bigger issue is the FED rate. If the Fed rate increases by .25%, then the margin rate is probably going to increase buy the same amount. Checking the margin interest rate should be first on any covered writer's list and this should be determined before margin is used.
