... more than just covered calls!

Margin Strategy

There are two issues to resolve before entering a margined position.

1. What is the margin interest rate.   This is the interest of the funds that are 'borrowed'.
2. What is the margin percentage for the stock in question.

Depending on the volatility of a given stock the margin percentage rate will vary.  This is amount the firm is willing to 'put up' towards the purchase of a stock position.  The best 'deal' is going to be 50/50.  It is important to understand that for some stocks the rate is 70/30 as an example.  This means the investor is required to provide 70% of the cost of the stock, while the firm is willing to provide the remaining 30%.

Remember . . . you are paying interest of the money you are borrowing.  Here is an example of how margin works.  For this example, the math for this example is based on the assumption that the margin percentage rate was 50%.

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TTWO    Take-Two Interactive Software, Inc.

THE (Initial Position) TRADE  DATE :    March 16, 2004

THE STOCK:    Take-Two Interactive Software, Inc. - TTWO develops and sells interactive entertainment software games and accessories for PCs, and for game systems offered by Sony, Nintendo and Microsoft.

THE STRATEGY:  Establish a new Initial Position using margin.

THE THEORY:   The theory behind Initial Positions has already been discussed.  The difference with this position is that it was established using margin.  A margin position is where the investor provides the funds for half of the stock purchase and borrows the funds from the brokerage firm for the other half of the purchase.  When the stock is sold, the investor is obligated to pay back the loan.  The investor is also obligated to pay interest on a monthly basis as it is accrued.  Keep in mind that if the investor sells a call option against the stock that was purchased, the investor keeps 100% of the premium (even though they put up half the cost of the stock)

THE COMMENTARY:  To see the power of using margin, let's look at this position through two set's of eyes.  First, without using margin and then second, with the use of margin.  Here is the Initial Position that was established in March of 2004.

Date	Strategy		Position	Investment	Generate	Total
16-Mar-04	Initial  Stock Purchase		Buy 100 TTWO @ 34.37	($3,462.00)
			Take-Two Interactive Software
16-Mar-04	Initial Covered Call		Sell '05 Jan $35 LEAP @ 5.90		$565.00
						$565.00

In January 2005, TTWO was trading below the $35 strike price and so the Jan $35 option simply expired.  The covered writer maintained possession of the 100 shares of TTWO and the $565.00 in cash, which is nothing more than one of the two possible outcomes of every Initial Position.  The covered writer used the Recover After Expiration strategy and sold a new call option against the same stock.  Here is the transaction data update.

Date	Strategy		Position	Investment	Generate	Total
16-Mar-04	Initial  Stock Purchase		Buy 100 TTWO @ 34.37	($3,462.00)
			Take-Two Interactive Software
16-Mar-04	Initial Covered Call		Sell '05 Jan $35 LEAP @ 5.90	Expired 1/22/05	$565.00
24-Jan-05	Continued Trade		Sell Jun $35 call @ 2.85		$260.00
						$825.00

In April of 2005, TTWO issued a 3:2 stock split.  This meant that the covered writer now had 150 shares of stock and the $35 call was split to the $23.33 strike price.  Note that when a stock splits, the options split at the same ratio.  A 3:2 (three for two) split means that for every two shares that are held pre-split, the investor will have three shares post-split.  What is the new option strike price.  Everything has to stay 'even'.  Before the split . . . 100 shares X $35 = $3500 . . . but now the 100 shares are equal to 150 shares.  Therefore, the strike price must split also.  Here is the math ...  150 shares X $23.33 = $3500. A stock split does not change the total amount of money an investor will receive if the option that was originally sold, is exercised.

The transaction data is adjusted to show the split as follows:

If the option is exercised, the covered writer will have to provide 150 shares of stock and the writer will receive $23.33 per share.  In other words . . .nothing has changed.  The writer will still receive $3500 if the option is exercised.  (150 x $23.33 = $3,500).  As it turned out this is exactly what happened.  TTWO was trading above the $23.33 strike price on June 20, 2005 and the option was exercised.  The position is now 'back to cash' with a predetermined gain as illustrated in the transaction data below.

Date	Strategy		Position	Investment	Generate	Total
16-Mar-04	Initial  Stock Purchase		Buy 100 TTWO @ 34.37	($3,462.00)
			Take-Two Interactive Software
16-Mar-04	Initial Covered Call		Sell '05 Jan $35 LEAP @ 5.90	Expired 1/22/05	$565.00
24-Jan-05	Continued Trade		Sell Jun $35 call @ 2.85		$260.00
11-Apr-05	3:2 Stock Split		Now 150 shares and $23.33 strike price
20-Jun-05	Option Exercised		Sell 150 TTWO @ 23.33	$3,475.00	$13.00
			Net Cash Gain			$838.00

The position generated a net, back to cash, profit of $838.00.  Without using margin, the percentage gain is 24.21%.

Total Cash Generated / Net Cash Invested = Percentage Return

$838.00 / $3,462.00 = .242056 = 24.21%

How long did the position last?  Approximately 15 1/4 months.  When the covered writer divides a percentage return by the duration (in months) and multiples the result by 12 (months in a year), the annualized return is generated.

(24.21% / 15.25) X 12 = 19.05%

Not bad!  As it turned out, this is not what really happened!  The covered writer did not have $3,477.99 in cash in the account on March 16, 2004.  No cash equals no Initial position . . .  but wait . . . what if the covered writer entered the exact same position using margin?  Here would be the 'margin scenario'. 

Date	Strategy		Position	Investment	Generate	Total
16-Mar-04	Initial  Stock Purchase		Buy 100 TTWO @ 34.37  ON MARGIN	($1,731.00)
			Take-Two Interactive Software
16-Mar-04	Initial Covered Call		Sell '05 Jan $35 LEAP @ 5.90		$565.00
						$565.00

Note that the covered writer is providing one half or $1,731.00 of the funds needed to purchase the stock.  The writer is also agreeing to pay the interest on the other half!  Assume that the interest rate is 8% (it's actually less than that as of this writing).  With that assumption the position would end as indicated below.

Date	Strategy		Position	Investment	Generate	Total
16-Mar-04	Initial  Stock Purchase		Buy 100 TTWO @ 34.37     ON MARGIN	($1,731.00)
			Take-Two Interactive Software
16-Mar-04	Initial Covered Call		Sell '05 Jan $35 LEAP @ 5.90	Expired 1/22/05	$565.00
24-Jan-05	Continued Trade		Sell Jun $35 call @ 2.85		$260.00
11-Apr-05	3:2 Stock Split		Now 150 shares and $23.33 strike price
20-Jun-05	Option Exercised		Sell 150 TTWO @ 23.33	$3,475.00
20-Jun-05			Pay back margin principle	($1,731.00)
20-Jun-05	$1731 borrowed for 398 days		Total interest paid compounded daily @ 8%	($157.76)	($144.76)
			Net Cash Gain			$680.24

For this position, the covered writer is providing $1,731.00 of the funds necessary to purchase 100 shares of TTWO on March 16, 2004.  There is 'no cash' in the account.  The funds come from the fact that the writer owns other positions in the account, which could be changed from a 'cash holding' to a 'margin holding'.  How this works is not the point of this example.  Keep in mind that the only way this position could have been established was through the use of the SysCW Margin Initial Position strategy!

Back to the closed position.  Notice that the 'investment' was $1,731.00.  The investment is defined as the amount of cash the writer invests in a given stock position.  The writer received the same $3,475 for the stock when it was sold, but had to pay back the loan principle of $1,731 to the brokerage firm (this is automatically accomplished when the stock is sold).  During the holding period, which in this case happed to be 398 days, the covered writer was charged interest at the rate of 8%.  The total amount of interest can be computed using an amortization table.  This amount computes out to be $157.76.

Take a look at the investment column.  The investment by the covered writer was $1731.00.  The stock was sold for $3475.00.  When the sale took place, the writer pays back the principle that was borrowed of $1731.00.  During the duration of the position, the covered writer also paid $157.76 in interest to the brokerage firm.  The net result of the stock position is a loss of $144.76.

$3,475 - $1731 - $1731 - $157.76 = ($144.76)

The covered writer had to pay $157.76 in interest in order to borrow the money.  Because the money was borrowed and the position was covered using the strategies of SysCW, call premiums were generated.  The net result, factoring in all commissions as well as the interest is a back to cash gain of $680.24.  Now comes the 'kicked up' part.

What did the covered writer invest?  The writer invested $1731.00 plus the interest of $157.76!  This is what the writer had to pay to own the stock.  This is the 'investment'.  Now . . . what was the gain?  The net result was a back to cash gain of $680.24.  Okay ... so what is the percentage gain?  The math is the same ... math is math ... recall from above:

Total Cash Generated / Net Cash Invested = Percentage Return

$680.24 / $1731.00 = 39.298%

When this return is 'annualized', it becomes 30.92%.  The bulk of the conservative nature of a covered call position is still present, but with an increased return through the CONSERVATIVE use of margin.  Want a higher return than covered calls can provide?  Then use margin!  Why?

•     The covered writer does not have to 'watch' the position on a daily or weekly basis.  There is not ... what if it goes up ... what if it goes down.  You're covered!

•     The premiums from the call options are immediately available as cash generated! 

•     The potential return is increased and yet the investor still has the premium generated as 'downside' protection.

It is imperative that a covered writer remain in control of the use of margin.  NEVER, EVER, use margin amounts greater than 25% of the account liquidation value or the net amount of cash currently used to fund the account.  Don't get greedy . . . it's not worth it.

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One final comment . . . For this example, the investment was listed as 1/2 the actual investment for illustrations purposes only.  As you will see with other examples . . the writer maintains the data as if the purchase were not on margin and simply computes the return both way when the position is closed.

PLEASE NOTE THAT THIS EXAMPLE IS NOT TO BE CONSIDERED AS A RECOMMENDATION TO INVEST IN TTWO 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 suggesting 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 provide for 'educational purposes' for the sole purpose of illustrating the Systematic Covered Writing strategies.

Thank you!

SYSTEMATIC COVERED WRITING
Copyright © 2005. All rights reserved.
Revised: 02/05/07