Understanding The Risk Of Margins, Selling Naked CALL & PUTS

To understand what is a margin call, we must first understand what is a margin loan.

A margin loan happens when you borrow money from your brokerage to invest or trade. In order to do that, you will need to apply for a margin account instead of a cash account. In exchange, you will need to pay interest to the brokerage.

What Is Maintenance Margin & Why It Matters?

In addition, you will need to meet the requirement of the maintenance margin set by your brokerage. Maintenance margin is the percentage of your own funds divided by the total value of the market investment/ trade that you are buying. Refer to the below example for a better understanding of how maintenance margin works.

Margin Call

A margin call happens when the investment/ trade that you use borrowed money to achieve drops in value or the trade goes against you and the maintenance margin is not met. As a result, you will get a margin call from your brokerage.

In a margin call, you will have to either deposit more funds into your account or if you have no money to deposit, the brokerage will liquidate your position, i.e. sell any of your open positions to release funds back to your account to meet the maintenance margin requirement.

Example/ Illustration

Take, for example, you wish to buy 100 shares of Tesla (assuming trading at USD1000) but you do not have USD100,000. You only have USD50,000 in your account, so you borrowed USD50,000 from your brokerage to buy 100 Tesla shares, which may charge you 2% interest on that 50,000. Your brokerage also expects you to have a maintenance margin of 25%, which you have met at the start of the trade as your maintenance margin is:

50,000 (your money) / 100,000 (total market price of 100 Tesla shares) = 50%

For some unexpected reasons, Tesla’s share price drops to $600 and the total amount you will get back from your investment now is $60,000. Minus off the margin loan that you owe the bank, you are only left $10,000. So your maintenance margin becomes:

10,000 (your funds) / 60,000 (total market price of Tesla) = 16.67%

Therefore, you have not met the brokerage’s requirement of a 25% maintenance margin.

In this case, you will need to top up more cash. another $5,000 into your account in order to meet the maintenance margin of 25%.

Your funds after top up = 10,000 + $5,000 = $15,000

Your maintenance margin after top up = $15,000 / $60,000 = 25%

If you do not have $5,000 to top up, then your brokerage will either sell away other postions in your account or close this trade for you, thus realising a $40,000 loss for you.

Selling Naked CALL/ PUT Contracts
The risk of selling naked CALL or PUT contract has been covered in another article that I wrote earlier so I shall not further elaborate here, you can refer to this article for more info: Why Are CALL and PUT Options Commonly Known As Covered CALL and Cash Secured PUT?

In the case of selling a naked PUT contract, you will need to find the funds to buy 100 shares of the underlying at the agreed strike price if the contract is exercised.

It gets worse for selling a naked CALL if things do not go according to your plan. You may suffer a huge loss if the share price increases by a few hundred percent as you will be forced to buy them back at a much higher price to honor your CALL contract if it gets exercised.

My Thoughts
I have never liked the idea of trading on “borrowed money” though it can get very tempting in a bull market where the odds of winning are higher. However, like the weather, anything can happen in the stock market. A stock market crash can happen when few people expect it, for example, in the case of the collapse of Lehman Brothers. When that happens, I will suffer margin calls on my margin loans and be forced to sell away my share positions at a loss.

As for selling naked CALL/ PUT, it is like playing with fire to me. When things go wrong unexpectedly, I will get burnt terribly.

The stock market can be a wonderful place to increase our wealth fast and help us reach our financial goals sooner but it can also be a dangerous place to lose all our money if we choose to take on high-risk trades or make risky decisions.

Therefore, I would rather find other ways to increase my capital than to take on the risk of borrowing money to fulfill my trade, because by doing that, I will have zero chance of getting into the situations/ worst-case scenarios described above.

I hope this article has been useful to you if you are considering whether to take on margin loans or sell naked calls to make more money. Invest safe, everyone!

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