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This is a level 1 question.
Can you review margin requirements and how to calculate it for us?
Let's first start with a simple purchase of stock shares. When you purchase shares of a particular stock, you can pay for them in either cash or use a margin account. Buying stock for cash is easy and is a relatively low quantifiable risk. This is because the maximum potential loss is known in advance and is limited to what you fully paid up front for the shares. If the stock were to collapse to zero, you would not be called upon for additional funds.
Contrast this with the investor who purchases stock on margin. When an investor purchases stock on margin, he/she borrows money that must be repaid in full. They also must pay interest on the money loaned. If the stock declines below a certain amount, the investor will be called upon (via a margin call) to make up the difference. It is this potential liability that accounts for the riskiness of trading on margin. By using margin, investors can create greater percent changes in their equity accounts than a fully paid stock in the cash account. This is the power of leverage.
The formula used to calculate stock margin is:
Equity Account + Margin Debit = Account Value
An account's value is the total market value of purchased securities. The margin debt is a loan from the brokerage firm to you and the equity account is your share of proceeds after the stock is sold and the margin debt repaid.
Initial margin is the minimum equity needed in your account to establish a marginable transaction. Initial margin requirements are frequently expressed in percentage terms of the position's value. Purchasing stock is a marginable transaction that has an initial margin of 50 percent. For example, a purchase of 1000 shares of an $80 stock requires an initial margin of (1000 * $80 * .50) or $40,000 plus commissions. A loan for the rest of the value of the stock would total $40,000.
If a margined position loses money, the equity in the account will decline possibly falling below the minimum margin level. The minimum margin is the level in which the account must be maintained. If the account falls below the minimum level the brokerage firm will notify the investor via a margin call to bring the account back up to appropriate levels. The maintenance margin is the level to which the account must be raised when a margin call is received. When an investor receives a margin call, he/she can either deposit additional funds or marginable securities or close the position.
In the above case, if the stock declined from $80 to $60, this would cause a decline in the equity account to $20,000. Notice that the margin debt does not decrease when the market drops rather it is the investor's equity that does.
| Equity Account | Margin Debt | Account Value | | $40,000 | $40,000 | $80,000 (1000 * $80) | | $20,000 | $40,000 | $60,000 (1000* $60) | $20,000 / $60,000 =33.33 percent is less than Maintenance margin of 40 percent.
$24,000 / $60,000 = 40 percent equals compliance.
$4,000 needed to break account back up to compliance levels.
If the maintenance margin were 40 percent, the account equity would be under the requirement, and the customer would receive a margin call for $4,000 to bring his account back up to compliance.
Now let's take a look at how to calculate margin on options. Let's use as an example the writing (selling) of some put options. One caveat about shorting put options. Put writing typically involves selling an out-of-the-money put on a quality stock that the investor would be willing to buy if the stock experienced a temporary plunge. However, the majority of the time, the put sold will expire worthless, allowing the investor to pocket the premium and receive a 10-to-15-percent profit without ever having to buy the stock. However, you should be financially able to acquire the stock on the rare occasion when it does drop. While there is a margin requirement when selling puts, this commitment of funds might be compared to the outright purchase of the equivalent number of shares. Put selling takes advantage of the concept of time decay - the option's value declines as the option approaches expiration.
Let's look at an example: With two weeks until the February series options expire, you realize that the stock XYZ has been holding firm above the 55 level. You anticipate this level will continue to provide support and with the stock at 57, you sell an out-of-the-money February 55 put for 1.50 points or $150 per option contract sold. At expiration, XYZ closes at 57, meaning the put expires worthless and you keep the 1.50 points of premium collected. The initial margin requirement for the transaction is 20 percent of the underlying stock plus the credit received, less the amount out-of-the-money. Therefore, this would be $1,090 per contract (($57 per share * 0.2 * 100 shares) + $150 from credit – ($100 * (57 – 55)). This results in a profit return of 13.76 percent ($150 in premium received / $1,090 in margin). Had the stock fallen below the key 55 level before expiration, you would have had to purchase 100 shares at 55 for each put option contract sold.
Let's take another example and calculate the margin and minimum margin requirements. Say that XYZ Corp. is at 62, and you are fairly certain it won't fall below 60, so you choose to sell a 60 put at the market price of 1.25 per contract. The Securities and Exchange Commission (SEC) requires that you have a margin account to sell an option, and most brokerage firms require the margin to be 20 percent of the value of the underlying stock, plus the option premium received less the out-of-the-money amount, for a total of $1,165 in this example.
| 20% of the value of the underlying stock | 20% * 100 shares * 62 | = $1240 | | Option Premium Received | 1.25 * 100 | = +125 | | Out-of-the-Money Amount | (60 – 62) * 100 | = -200 | | Total Margin Required | = $1,165 | | Return on Margin | $125 / $1,165 | =10.73% | | Minimum Margin Required | (62 *.10*100) + (1.25 * 100) | =$745 |
The minimum margin requirement is 10% of the value of the underlying stock plus the option premium received. So if this is larger than the number derived by the formula above, the larger number must be used. As long as XYZ Corp. ends above 60 on the day the option expires, you will keep the amount received from the initial sale of the option. However, if XYZ Corp. shares do not close above 60 on that day, you will have to buy back the option for whatever it is worth. Also, there is a chance that the options will be exercised, which means the option seller will have to purchase the shares of the underlying security (which is why the margin account is required). However, the options sold in a put-selling portfolio will be written on solid, large-cap names. If they decline to a point where the put options are called, you will buy the shares, which is also a positive since a quality stock will be purchased at a relatively low price and is likely to recover the lost ground, allowing for profits from the purchase.
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Question Level Key
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Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
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