The following is a brief explanation of how a margin account at your broker works to substantially increase your returns when SELLING puts. This is an advanced concept in trading and takes a while to understand so I wanted to explain it as simply as I could to my daughter, nieces and nephews. I sent this email out to them to help them understand it.
It is a hypothetical example that is simplified as to the real estate transaction I used to illustrate it with AND exaggerated with regards to the selling of the put to make the illustration as clear as possible. It is the theory behind the whole transaction I was trying to get across to them.
--------below is the body of the email, enjoy---------
More aggressive/advanced investors will use margin to sell puts on them and substantially increase your cash on cash return.
Cash on cash return is a term I take from income producing real estate. The easiest way to explain it is to use an example:
Lets say you want to buy a house to rent out for income.
Assume the house costs $100,000.00
You finance $80,000.00 with the bank and put down $20,000.00 out of your pocket to do the deal. (this is your CASH)
The property generates rents of $1,000.00 per month (this is your RETURN or cash throw off if you want the technical term).
You may think that the return is 12%. Because the house costs 100K and generates gross revenue of 12K every year.
To calculate the return you divide the 12K by 100K and you get 12% 12K is 12% of 100K.... so your cash on cash return is 12% right?
WRONG....
You only used 20K of your own money to finance this deal. the cash throw off is 12K
So divide 12K by 20K and your cash on cash return is 60%...remember you only put 20K of your own money into this.
Now there are many expenses that chop this GROSS income number down, like debt service (the mortgage payments), taxes, insurance, repairs, vacancies, etc. BUT your actual cash on cash return is going to be substantially HIGHER than 12% unless you are a total retard and have no business being in the rental business.
This is where the power of selling puts USING MARGIN on a great company can create huge cash on cash returns in a standard stock brokerage account.
Again, the easiest way to explain this is through the use of a simplified example.
First a term or two - Margin is credit - plain and simple.
Using margin with a broker is using credit. However, it is alomst interest free when you SELL options.
How can this be you ask?
Well, if you have a margin account (credit account) when you sell a put you are actually BORROWING the shares from the house to be bought by you at a future date. Depending on how good your credit is with the broker (the house) you can only put up as little as 20 or 30% of the money as collateral towards the eventuality of you being 'put' (forced to buy) the shares at the future date.
So let's step through this.
You have a stock that trades for 100 dollars. Each put option controls 100 shares at or BELOW a certain price.
You are insuring the BUYER of that put option that you will BUY those 100 shares at the agreed upon price in the future no matter how LOW the price of the underlying stock falls before and up to the closing date. Now you will have to SPEND the agreed amount on the underlying stock at that time at the expiration. This is known as the strike price and any amount OVER what the actual stock price is at the time you will need to cover with your money to buy the shares.
This is insurance for the BUYER that he will not lose any more than a certain amount of money on his holding in that stock because if it falls BELOW the strike price (the price you agreed to buy it from him for) You will have to pay that price for those 100 shares.
If you do not have margin or credit with the broker, that tranche of 100 shares you are selling the put option on has to be backed up by the strike price amount of cash X 100. Or 100% of the money needed to buy all 100 shares. Thats $10,000
But using MARGIN you only need, say 30% of the total price of all 100 shares. Thats $3,000
So you see using margin and selling puts increases your cash on cash return much like using financing to buy rental real estate does.
Here is the example in action
Sell a put of a 100 dollar stock for 10 dollars - strike price 90 dollars.
Say your margin rate is 30%
Instead of having to have $9000 in your account in cash backing up the trade NOT using margin you only need to have
30% of $9000, or $2700 cash in your account USING MARGIN
Assuming your trade does NOT go against you you are collecting $1000 ($10x100 shares) wth only $2700 of your actual cash in hand. This is a cash on cash return of 37% This sort of return is HUGE and can be repeated several times each year to generate ridiculous growth in your portfolio
This sort of set up does NOT always happen to this extreme , but I am exaggerating the example to illustrate the point.
If you have ever heard of a 'margin call' wiping people out it is just this sort of trade that will do it. If you only have $2700 cash in your account and the trade goes against you you HAVE TO COME UP WITH the other $6300 by the close of business that day....
If you watch the movie Trading Places with this illustration in mind you will finally understand WHY Billy Rae and Louis were so happy and the Dukes were so upset at the end.
This CAN be very confusing - and doing this type of thing WITHOUT having an expert stock picker choosing your underlying stocks is VERY dangerous.
That is why I am forwarding these types of newsletters to you.
I can help you navigate this and guide you so you do NOT hurt yourself, while earning outsized gains in ANY market - Up - Down - or sideways....