GOOGLE, INC.
New Margin Rules (Part II)
by J.L. Lord
I wrote in the June 2007 issue of STOCKS & COMMODITIES, while the new margin rules are a powerful addition to retail traders, they do not imply there is free money to be had. Interest is a key component of the new margin requirements. Under the old rules, the interest component was overshadowed largely by the excessive capital requirements that unnecessarily reduced your purchasing power. In the new world of risk-based margin, the interest component now stands out as a significant portion of the puzzle.
WHY IS THERE AN INTEREST CALCULATION?
Suppose you purchase 100 shares of Google, Inc. (GOOG), for $450 per share. The total cost of that investment would be $45,000. There are several ways to come up with the money. You can take the money out of your bank account. If you had $45,000 sitting in the bank, it was comfortably earning a certain amount of interest. Another way to make the purchase is to borrow some or all of the money. In this case, you would be responsible for making interest payments to the establishment that lent you the money. A third way would be a combination of the two. When a broker allows you to buy stock on 50% margin, you are responsible for coming up with the interest on the 50% of the money you borrowed in order to complete your stock purchase.
Here you will see a simple interest calculation that assumes an annual interest rate of 6%. This makes the 30-day interest component 0.5%. In practice, the interest rates may differ and be compounded daily, monthly, or in some other denomination. You would be best served by asking your financial institution for the details.
FACTORING INTEREST CALCULATION
Going back to the example of a stock purchase, if you were to purchase 100 shares of GOOG for $450 per share and held that position for 30 days, you would be taking $45,000 out of your interest-bearing account for 30 days in the hopes that GOOG's return would exceed what the bank pays you. A simple interest calculation using earlier assumptions shows that the interest on $45,000 over a 30-day period would be $225. In other words, this $225 represents the interest as foregone. It means that you expect GOOG to rise in excess of $2.25 per share over the next 30 days. Otherwise, you would have been better off leaving your money in the bank.
For most retail traders, the $45,000 requirement to trade GOOG dwarfs the $225 interest component. Therefore, retail traders usually do not receive the necessary education regarding interest. Under the new rules, interest is a relatively larger portion of the value of the trade. Hence, it will receive the attention it deserves.
WHERE DOES INTEREST SHOW UP?
Consider a position under the old margin rules where a trader buys 100 shares of GOOG for $450 per share and buys one 30-day 450 strike put option for protection. Initially, the margin requirement would have been 50% of the stock's purchase price multiplied by the number of shares plus the value of one long put contract. Under those numbers, the total margin requirement came out to $23,500.
But to complete the requirements, you have to factor in the interest component. Keep in mind that you have to come up with $45,000. You gave our broker half that amount, meaning that you made a 50% down payment on the purchase. That means you have borrowed the other half, or $22,500. Using these assumptions, a simple interest calculation shows that over a 30-day period, if you borrowed $22,500, you would have to repay the $22,500 plus an additional $112.50 in interest. This would make your total margin requirement at the end of the 30 days $22,500 (50% margin) + $1,000 (option premium) + $112.50 (interest component), giving you a grand total margin payment of $23,612.50.
HOW DOES THIS CHANGE UNDER THE NEW RULES?
Under the new rules, given that the 450 strike put protects you against any downside move in GOOG for the next 30 days, you are only responsible for $1,000 - the total combined risk to the position. (The details were explained in part 1.) However, keep in mind that even though you do not have any stock at risk in the position, you still bought 100 shares of a $450 stock. Therefore, you have still made a $45,000 purchase and must pay the corresponding interest. Note that you have borrowed all $45,000. This is similar to purchasing a home on one of those no-money-down plans. You still have to pay interest on every cent you borrowed.
Given that you have purchased a 30-day option, if you assume that you will hold the combined long stock and long put position for 30 days, you can assume that you will pay interest over those 30 days. According to the earlier assumptions, the interest on a $45,000 loan for 30 days would be $225. Therefore, the total margin requirement on your stock and put position for 30 days would be $1,225. This represents a savings of $22,387.50 over the requirements using the old margin rules.
Note the drastic changes in necessary funds to place the same trade. Nothing has changed but the rules governing the margins. Maximum risk remains unchanged. While you previously needed nearly $25,000 in order to successfully trade GOOG, you can now obtain those same positions with protection for a tiny fraction of the old requirements.
LAST THOUGHTS
There are a myriad of strategies that will take advantage of the new margin rules, including but not limited to collars, such as reverse collars, gamma scalping, and various synthetic positions that can be used with various forms of options arbitrage. Over the course of both parts of this article, we have shown the advantages of the rules in a married put position. A logical next step in addition to purchasing stock and a protective put would be to sell an upside call in order to partially pay for the put purchase. This position is what is referred to as a collar.
As a word of caution, note that without taking the interest component
into consideration, the collar under the new margin rules may at first
glance appear to be a risk-free trade. This is why it is important to take
the time to learn about the new rules before implementing them into your
trading strategy.
J.L. Lord, the author of a series of option trading texts, can be reached at RandomWalkTrading.com.Suggested reading
Brubaker, Jonathon [2007]. "Random Walk Trading," product review, Technical Analysis of STOCKS & COMMODITIES, Volume 25: June.
Lord, J.L [2007]. "New Margin Rules (Part I)," Technical Analysis of STOCKS & COMMODITIES, Volume 25: June.
_____ [2006]. "Stock Options And Collars," RandomWalkTrading.com.
_____ [2006]. "Option Greeks For Profit," RandomWalkTrading.com.
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Originally published in the August 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.