Selling Put Options with a Margin Account

I’ve written a lot about options in my three part options primer.  I also wrote a brief primer about how a margin account works.  What we need to do now is to put these two concepts together and discuss why you should be excited about the prospect of selling put options using a margin account.  Using this strategy can seriously juice your returns if you are willing to take on the additional risk associated with trading on margin.  With that in mind, we will also cover what kinds of risks are involved in this scenario and discuss some of the ways that you can work to mitigate that risk.

It all begins with the cash-secured put

In the beginning, there was the humble cash secured put.  In its most basic form, in order to sell a put option you must have enough cash in your account to cover the cost of purchasing the underlying stock at the strike price of the put should the option be exercised.  That cash will remain locked away by your broker until assignment, the put expires, or you close out the option buy buying back the put.

The downside of selling cash secured puts using this strategy is that you have to keep a pile of cash in your account that is dedicated to doing nothing other than waiting for a put to be exercised.  This isn’t as bad as it sounds since I was essentially earning more than 10% annual returns on that cash.  This is as good as the dividend yield of most of my high yield stocks.

However, in the long run, that cash may have been better invested in dividend paying stocks with strong dividend growth rather than just sitting around in a money market account earning a pittance in interest.

Enter the margin account

Margin accounts allow you to borrow money from your broker so long as you keep a certain amount of cash and equities in your account to be used as collateral.  While I’m not to thrilled about using margin accounts for standard run of the mill stock trading, I’m ecstatic about how a margin account can be used with options.

Remember above when I said that you have the cash on hand should the stock be assigned to you?  Well, in a margin account, the marginable funds take the place of the cash.  So your put is still “cash secured” but instead of being your money, you use the broker’s.

But isn’t this a loan? And don’t you have to pay exorbitant interest?

Yes and no.  For the duration that the put is in effect, NO.  You only have to pay interest if the stock is assigned.  This is a phenomenal improvement over having to have my own cash on hand when I sold put options.  To use myself as an example, when I switched over to a margin account, $8,000 that I had “secured” due to put selling suddenly got freed up for investment in dividend paying stocks.

The end result is that all of my available cash can now be used to invest in dividend paying stocks, I still get to sell puts, and I only have to worry about interest charges if the put is assigned.

Mitigating risks

Just because your cash is now free doesn’t mean that the risk of assignment went away.  It’s still there.  And it’s even worse because once the stock is assigned you’ll have to start paying exorbitant margin interest on the value of the stock.  Below are some general guidelines to help lower the amount of risk associated with selling puts in a margin account.

Only sell puts against stocks that you would like to own at a price you would be willing to pay

Remember that if you are assigned the stock, you are stuck with it.  The fact that you would have bought a stock at a given price (strike price minus option premium) won’t eliminate the risk of assignment, but it will virtually eliminate the possibility of being assigned some junk stock that you never wanted in the first place.  If you’re a dividend growth investor like I am, don’t sell puts against Google or Zynga just because you think you might be able to make a quick buck off of it.  Instead, I sell puts against companies like Coca Cola and Conoco Phillips.  I certainly wouldn’t mind owning more of these companies.

Pay attention to your leverage

There are two different leverage measures that you need to be aware of.

First, you need to pay attention to how much of your potential marginable funds have been devoted to puts.  Remember that these funds fluctuate with account value.  So if the market goes up and your equities increase in value, you can sell more options.  If your equities decrease in value, then your ability to sell options decreases as well.  If your account value drops by too low, you may be subjected to a margin call.

Second, you should pay attention to the absolute amount of capital that is at risk.   Meaning that should all of your puts be exercised, how much money will you have to cough up to pay for those stocks that have now been assigned?

Stagger your options

Sell options with expiration dates two or three months apart. An option’s value depends on how much time remains until the expiration date and whether or not the current stock price is below the strike price.  Even if the option becomes in the money it might not be exercised if the option itself still holds some value.  By staggering your options sales across the year, you’ll be less likely to encounter a scenario were a small market downturn leads to all of your options being assigned at once.  However, options can be assigned at any time, so this i not a full time protection.

Don’t be afraid to cut and run

If the underlying stock hasn’t substantially increased in value (or has even decreased in value) a few months after you sold the option, it might be a good idea to buy back the option and close out the contract.   You might only break even after commissions or maybe even lose money, but that’s a pittance compared to being assigned a stock that you don’t want.

Embrace assignment

Maybe you feel that a certain option has a big likelihood of being assigned.  Since you only sell options against stocks you would like to own, it’s perfectly reasonable to use assignment as a way to enter into a position. If you decide to take this route, it might be a good idea to start building up funds in your account in order to cover the cost of assignment.

And if you’re not assigned, you can always deploy the cash towards some other purpose.

Tap your cash reserves

I am building a needlessly large emergency fund.   One great use for this fund would be topping off my brokerage account should I be assigned a stock.  I might wind up having to soak a day or two of margin interest, but in the grand scheme of things that’s not too bad.  Then I’ll just rebuild my emergency fund over time.

Technically, this suggestion probably violates all kinds of emergency fund guidelines, but unless you’re going to keep a bare-bones emergency fund, I would consider tapping your emergency fund to seize investment opportunities.

Sell the stock

This one is self explanatory.  If you get assigned the stock, just sell it at a loss.  Just because you are assigned a stock doesn’t mean that you have to keep it.  Maybe you don’t want it any more or maybe you can’t cover the full cost of assignment easily.  There’s nothing wrong with that.  Just sell the stock.

Readers:  Do you sell put options in a margin account?  How do you manage risk?