You don’t need to use leverage (also known as margin) to trade options, but what would be the point of trading options? Leverage is a double-edged sword: mighty in good times, disastrous in bad times.
So, how do you decide when to use leverage and how much to use? The key to using leverage is understanding one simple Robert Kiyosaki quote, “There are no risky investments, only risky investors.”
Therefore, investors choose how to wield the power of leverage. You can control your own destiny, whether that means success or destruction.
Don’t Gamble with Retirement 13
Today, I want to review some ways to de-leverage yourself before you enter the market. Additionally, once you enter the market, I want you to gauge your own risk tolerance and margin appetite. If you can do those things, you can become a successful, part-time options trader.
What is leverage, and why is it important? In a nutshell, leverage is using other people’s money to make (hopefully) successful investments.
People use leverage when they purchase a home using a bank mortgage. Typically, they put down 10-20%, and the bank lends them the rest.
The bank uses the property as collateral against the loan. Remember this dynamic, as it is vital to understanding leverage in the options market.
A simple way to understand leverage. There are two prevailing theories when using leverage in homeownership: Dave Ramsey and Robert Kiyosaki. Dave Ramsey says to pay one house down first completely, while Robert Kiyosaki promotes using as much leverage as one can handle (in simple terms).
My Three Favorite High-Yield Savings Accounts
Let’s play out both scenarios to see how they can affect the psyche of the investor. Let’s start with Robert Kioysaki’s real estate investing method.
Suppose someone has $100,000 and purchases five homes with $20,000 down payments each. This person will get richer from rental income much faster than standard techniques. However, if the renters couldn’t pay, the owner would be leveraged to their eyeballs.
Conversely, the Dave Ramsey investor uses the $100,000 to purchase a $300,000 home. They then pay off the home over six years and own it outright. They then purchase another home using the same technique.
The Dave Ramsey investor would get richer much slower but not face the same fears of being over-leveraged, an upcoming recession, or missing mortgage payments from renters.
Let’s focus on the option market. Now, we know that we can use leverage to build wealth slowly and discreetly or go in “full bore.” Neither way is right or wrong, but you must understand which way suits your personality.
Trading Long Strangles vs. Mortgage REITs
Using leverage in the options market starts with building a cash reserve in your brokerage account. You can keep this money in money market funds, index funds, or dividend stocks.
Once your brokerage account approves you for using margin in the options market, you can start “buying” options.
On a side note, you can sell covered calls and cash-secured puts as a level-one options trader. This beginner’s level does not use leverage; you must have the money or stocks in your possession to sell these protected options.
Let’s say you have $10,000 invested in a money market fund. The brokerage typically allows you to borrow $4,000 to $5,000 against this amount—roughly 40-50%.
Let’s say you have $10,000 invested in the SPDR S&P 500 (SPY) index fund. However, your account is worth $14,000 because of growth. The brokerage will let you borrow $7,000 against your account.
Life as an Income Investor 2
Rule #1 when using leverage. Never get anywhere close to your allowable margin amount. If I had $14,000 with a margin total of $7,000, I would use up to $3,000.
If you are over-leveraged, you could receive a margin call that forces you to sell assets to cover your loan. For example, you borrow $7,000 against your $14,000 total. If your total portfolio amount drops to $12,000, your margin limit would be $6,000. The brokerage could margin call you for $1,000.
You want to avoid putting yourself in these highly stressful, highly contentious situations. You can avoid all of this nonsense by betting well within your margin limits. I know it sounds like common sense, but “common sense is not a common virtue.”
Rule #2 when using leverage. Always, always know your timelines. When you “buy” options, they are slowly decaying until they reach zero dollars. As you get closer to the expiration date, this time decay increases—think of it as holding a hot potato.
For this reason, I trade long strangles strictly around earnings calls. I can set my long strangle to expire a month after the earnings date (to prevent high time decay), but I sell my positions on earnings day, no matter whether I win or lose.
The Options Wheel vs. Business Development Companies
Young options traders may have the urge to hold calls or puts based on a “hunch,” gut feeling, or lead. This is dangerous stuff to do with leverage.
Let’s say you have a hunch that SOFI Technologies is going to raise 20% over the next month. For this open-ended style bet (speculation), it is best to use your own money, meaning use your cash pile, not the banks.
Remember, when you use leverage, you are paying interest to the bank. Holding margin for a month can be expensive, and you want to factor it into your equations.
Between margin calls and fees, you can get into quite a bit of trouble. Avoid the gambling nature of option trading and go with the facts.
The fact is that if you buy (5) five SOFI call options for $500, you can’t lose more than that. Therefore, if you are willing to lose $500 when you initiate the trade, you can’t really lose. It’s vital you know the stakes before confirming the trade.
Dividend Growth Investing vs. Income Investing 2
Rule #3 when using leverage. You can use leverage to maximize gains and reduce risk. Let’s say you have a $15,000 portfolio of SPY shares with a cost basis of $10,000—that’s $5,000 of unrealized gains.
Instead of realizing those gains, you can leverage them. For example, you can purchase $3,000 in SOFI call options. If these options go to zero for some reason, you can sell shares to cover your loan.
You are still up $2,000 in your position, but you played your hand at a lucrative strategy that could have paid off. You were basically gambling with free money (unrealized gains).
The key to using leverage. The key to using leverage with options trading is avoiding emotional trading. You do not want to have good money following bad money.
Selling Cash-Secured Puts vs. Preferred Shares
Evaluate the stakes before you enter. If you don’t know the stakes, then you are gambling. Each option strategy has its own win conditions and risks.
I am a fan of trading long strangles. The risk here is that the stock price doesn’t move enough in either direction for me to make a profit. If that happens, I will probably lose 20-30% of my trade.
Conclusion. I take it a step further and only trade what I am willing to lose. If I buy $2,000 of call options and put options, I am willing to lose the entire $2,000.
The Dividend Savings Account
If I am down and have to sell, whatever I receive back in return is a bonus. How you alleviate risk and stress is up to you.
If you have a $10,000 margin limit and use $10,000, prepare for a margin call. Maybe you have $100,000 on standby—most people don’t.
Margin may be the banks’ money, but it’s your livelihood. If you are feeling stress and anxiety, your stakes are too high.
The best part of options trading is that you can control your own narrative. You don’t need to use leverage, and you definitely don’t need to over-leverage yourself when you do use it. Good Luck!
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