Optionetics.com TRADING FLOOR SECRETS: New Margins Tuesday January 9, 2:30 pm ET By Scott Kramer At the risk of hyperbole, one of the most substantial, beneficial and powerful rules to be implemented in the financial markets will take effect officially on April 2, 2007, though not every broker will be up to the challenge that early. ADVERTISEMENT The Chicago Board Options Exchange [CBOE] and Securities and Exchange Commission [SEC] has approved revised margins on stocks that are protected by options contracts. Under the terms of the new rules, investors who have a stock position that is protected by options contracts will have the potential to have their margin reduced to their actual risk. Up until now, anyone wanting to purchase stock on margin, even if utilizing a protective put for insurance purpose, had to put up ½ the stock's value, even if they could not lose that value. Old Margin A "put" option is a legally binding contract traded on many exchange floors that allows the owner the right (but not the obligation) to sell a specified amount of stock at a specific price prior to the contact's expiration date. Working just like homeowners' insurance, should your stock burn down you will be compensated for the loss at the insured value (strike price) minus the current stock price. If you owned the 100 strike put and the stock fell to $60 (from $101 a share), your put insurance policy would allow you to collect the $40 lost in the stock fire. Your loss will be the $1 per share difference between the stock price and the strike price plus the cost of insurance, but this is substantially less risk than an unprotected stock, or even the current 50% margin. If the put insurance cost you $2 per share, then your total risk would be $3 ($2 for the put and $1 stock risk). Under current margin rules you would have to put up the cost of the put and 50% of the stock value. If you wanted to purchase 1,000 shares of stock for $101 the $101,000 stock position would be margined at $50,500. Since each put option hedges 100 shares of stock and costs $2 per share, your insurance will cost an additional $2,000, for a total investment of $52,500. New Margin The new margins will allow investors and traders to reduce the $52,500 margin down to $3,000. Recall from above that the most one can lose on a hedged stock is the difference in price between the stock price ($101) and the strike price ($100), with the cost of the put ($2 per share) as additional risk. Since this comes out to be a total of $3 per share real risk the new margin rules will allow for many people to only have to put up the $3 per share, or $3,000 on the position described. This is POWER and leverage in the same league (or many instances greater) as commodities futures. What This Means To You For most people new to investing in either stocks or options, capital requirements tends to be the biggest obstacle after knowledge. With enough knowledge, hopefully capital eventually ceases to be an issue, so I stress knowledge as the number one obstacle that traders experience. We at Optionetics are doing all we can to fill this void, so I am focusing on how this new rule helps overcome the other problem new investors face: capital shortage. When I ask people to name a stock they would like to put a bullish or bearish position on in, they inevitably throw out names like GOOG, CME, etc. They want to play stocks that can move $5, $10 or $20 in a day. When I ask them what stocks they do play I often hear a barrage of cheap 4 and 5 (penny stocks) letter ticker symbols that I haven ever heard of and all the good points associated with the company. "Mr. Haney just brought a new load of genuine imitation alligator skin chairs over to Sam Drucker's store, which should boost annual sales of Hooterville's only store. I think the stock is poised for an explosion to the upside." There is a disconnect between what they would like to trade and what they actually trade because they can not afford Google but can afford the penny stocks, but this soon could disappear. As I write, GOOG stock is trading at $483.58 and the January 480 put is trading for $7.40. Under the old rule an investor who wanted to purchase even 100 shares of GOOG would have to put up $24, 179 in stock margin (100 shares X $483.58 stock price X 50% margin rate). He would also have to pay $740 for the one put contract to hedge the position. The new rules would require the trader to post the difference between the stock price of $483.58 and the strike price 480, multiplied by the 100 shares. This $358 of risk combined with the $740 cost of the put will be a total capital outlay of $1,098, or about 1/44th the stock value. This is obviously much more leverage than the ½ stock margin. A trader wishing to increase his or her size can now trade almost $500,000 worth of GOOG stock ($483,580) for an investment and margin of $10,980. Now that is leverage. How Will This Affect the Markets According to William Brodsky, chairman and chief executive of the CBOE: "The new margin rules will enable countless investors to employ trading strategies that previously were prohibitively expensive for all but professional traders." But Wait, There's More In some portfolios the margining rules will match the amount of money in a customer's account to the risk in the customer's portfolio in other ways. Portfolio risks in indexes is determined by calculating what the account's balance will look like after simulating for a 15% up and down move. A covered call, where one buys an underlying such as the SPYs and sells call options to receive money up front may no longer be margined at 50% even though the stock could conceivably fall to zero without the put for protection. Instead it would be margined at possibility as low as 15% movement, which would also be a dramatic improvement and allow as much as 75% greater leverage. The New Rules Will Also: The new rules will also likely increase volume dramatically in both the options and stock. What I have not found anyone touching on yet, but is almost certain to occur is, the artificial increase in demand for put options may force an even greater skew in put prices. Though this will create opportunities in other strategies it will still slightly force the cost of put insurance higher. The new rules will also confuse and frustrate many traders. Many people reading this will be waiting by their laptops on April 2 to begin taking advantage of this new "toy," only to be frustrated when they are informed their broker doesn't know anything about it. Depending on the level of sophistication and determination by the broker, a couple may be ready to go one the 2nd of April, and most others will be handing out excuses in place. Conclusion What this really means for everyone is that there is now no excuse for not trading the strategies and stocks you like, as money and risk levels will both be lowered. What should be done between now and April 2, 2007 is to get up to speed on the strategies you intend to implement to take advantage of this rule. Broken wing butterflies, gamma scalping, covered calls, collars, married puts and other strategies will be easier and cheaper to trade under the new margin rules. An increase in skew could benefit some of the strategies such as Broken Wing Butterflies while possibly being slightly more costly with married puts. No matter what you plan on trading, though, you should be attending retakes and reading all you can about the strategies until they become second nature. Get your friends and family involved, as many who were previously left out for financial considerations are now more likely to be qualified for trading these new strategies according to Mr. Brodsky. Get ready for a great 2007. Scott Kramer Staff Writer and Trading Strategist Optionetics.com ~ Your Options Education Site Visit Scott Kramer's Forum