The Right Way To Think About Margin Requirements When Trading Options
Today, I want to use this space to discuss a particular detail about a recent trade we made over at my premium Income Trader service.
What makes this trade different than any other?
Its high margin requirement.
If you’re familiar with how options work, then I realize you’re probably groaning right now. This is one of the last things a trader wants to deal with.
But in just a second, I want to explain how this is just one of many things that factor into the risk/reward calculation when it comes to selling put options.
It’s All About Safety
To understand this, you first need to know that this recent trade recommendation was in Autodesk, Inc. (Nasdaq: ADSK). The stock is on an Income Trader Volatility (ITV) “buy” signal, as shown in the chart below.
ADSK is a high-priced stock, which means that it will require a high margin requirement — and I know that is a concern for some traders. Two weeks ago, we had another trade in a high-priced stock (which we closed for a gain in less than a week).
But this kind of recommendation isn’t the start of a new trend. I know these trades tie up a larger amount of capital, which is something I try my best to avoid. But these higher-priced stocks are the only trades I have been finding that also meet my rigorous safety requirements. (Last week, we weren’t able to find a single trade that met these requirements.)
It all has to do with being in the midst of earnings season.
As a rule, I avoid holding trades in stocks that will announce earnings while our positions are open. On average, a stock’s price falls more than 2.5% in the week its company announces an earnings miss. Of course, that’s an average — some stocks fall much more than that. While most companies do exceed earnings estimates, the chance of a miss is large enough that I find it best to avoid that risk altogether.
My Process For Finding Trades
This is a prudent risk-management strategy.
As many of you know, I spent time in the Army — a place where risk management is extremely important. Risks include death, catastrophic injury, and damage to millions of dollars of equipment.
There are formal courses on managing risks in different environments. But grizzled veterans explain risk management by saying “just don’t do anything different or dumb.” I’ve followed that advice in my military and investing careers.
In a nutshell, this advice is basically saying, “Have a process and make sure you have the discipline to follow the process.” My process for Income Trader is detailed in an award-winning paper I wrote a few years ago.
My process involves searching for:
– Options that are expiring soon and have a high probability of expiring worthless. Preference is given to the options expiring the soonest.
– Options that will expire before a company announces earnings results.
– A minimum annualized return on investment of at least 10% until expiration.
– A “buy” signal on my Income Trader Volatility (ITV) indicator, which means the indicator is below its 20-week moving average.
The ITV indicator is the key to the success of the system. It shows the ideal time to sell options. It has proven itself year after year ever since I developed it. So, to avoid doing something dumb, I stick to my process.
Risk vs Reward
However, this also means that our universe of stocks to trade is smaller when earnings season is in full swing. And, for the past two weeks, the result of that smaller universe has been trades in high-priced stocks.
Let me reiterate, the higher prices don’t make these trades riskier than positions in lower-priced stocks; it only means that the margin deposit will be higher than some readers are used to seeing. Our return on margin is still within the range of what I normally target, and because the strike price is high, we will also receive a higher premium. The contracts still have the same high probability of expiring worthless. And the ITV “buy” signal is just as powerful.
Let’s turn back to the ADSK example. In this case, there were other factors that went into consideration. The company is scheduled to announce earnings at the end of November, and the recommended option will expire weeks before that. This minimizes risk.
As I mentioned, the stock is on an ITV “buy” signal. That also indicates risk is low. And the strike price of the option is well below the market price and below important support levels. This also reduces risk.
Overall, I am confident in the trade. Everything I see is pointing toward a high-probability, high-income opportunity.
When it comes down to it, the reason I’ve been recommending these higher-margin trades because I think they’re good trades. Period. But everyone’s situation is different. Maybe you don’t want to tie up too much of your capital in a trade. That’s fine, too.
But it’s something worth addressing. And again, margin requirement is just one of many factors to think about when looking at a trade. So before you automatically shy away from a trade requiring a high amount of capital, you may want to think again.
In the meantime, don’t forget to tune in for Jim Fink’s event “Election-Proof” trade event TOMORROW…
If you’re like most traders or investors, then you’re probably a little nervous about the upcoming election. But my colleague Jim Fink says he’s found the closest thing to a “sure thing”. In fact, he says this trade is completely “election-proof” — allowing you to come out ahead no matter who wins on November 3rd.
And on Thursday, Oct. 29th, at 1pm EST, he’s going to give it away, for free.