MARGIN LENDING

Click the picture left to view information about Margin Lending Benefits, Risks, and Margin Calls - this briefly explains benefits, and risks of Margin Loans, plus this has a good explanation of what a Margin Call are and how to meet them.

In recent years buying shares on margin has become a popular strategy for investors. By borrowing to purchase shares, you gain leveraged exposure to increases in the value of the shares selected. There may also be tax advantages in borrowing to purchase shares.

The accompanying chart demonstrates the increase in popularity by showing the rise in clients lodging stock bought on margin as collateral.

OPTIONS AND MARGIN LENDING

When share prices stay flat for a period of time, investors who have bought on margin traditionally have had two choices:

• 1. Ride out this period, and continue to hold your shares in the hope that they will rise in the longer term. In this case, interest costs are still being incurred, and you rely on dividends paid on the underlying shares to reduce your holding costs.
• 2. sell your shares.

Options give you a third choice, one which significantly broadens your investment opportunities.

How it works

When you sell a call option you accept the obligation to deliver a parcel of shares (usually 1000) of the underlying stock for a specified price (the strike or exercise price) on or before a specified date, if called upon to do so by the taker of the option. For this, you receive a payment (the premium).

For an example of this strategy, refer to Writing an at-the-money call option.

Writing at-the-money options (where the exercise price of the option is around the price of the share when the strategy is implemented) usually reflects a neutral view of the underlying shares on the part of the call writer.

If the share price at expiry is lower than the strike price, the option will lapse worthless. Even though your shares may not have increased in value, the option premium provides you with extra income. It also offers you limited protection in the event that the share price falls.

Should the share price at expiry be above the strike price, the option will be exercised, and you must sell the shares at the strike price.

Benefits

As an option writer, time decay (erosion of time value) is always working in your favour. The main attraction of the covered call writing strategy is that although the share price may remain flat or may fall, time decay means that you will make a profit on the sold option. You can look at this income almost as an extra dividend on your shares.

If the option is exercised at expiry, your total profit will depend on the exercise price of the option you have written.

Most call writers would consider the best result to be for the share price at expiry to be at or just below the strike price of the written option. If you have written an at-the-money option, this means that your shares have maintained their value, but the option has expired worthless, delivering you the premium as income.

Risks

The main risk of this strategy is that the stock price falls significantly. You still hold the underlying shares, and the written call option provides you protection only to the extent of the premium received. However, if the share price does fall, you will still be better off having written the call option than if you had kept your shares uncovered.

A second risk is that the stock shows unexpected strength. No matter how high the share price rises, as long as they are subject to the written call the most you will receive for your shares is the option’s exercise price (plus the option premium). Although not a physical loss, this is an opportunity cost to you.

How to write options over margined stock

For your shares bought on margin to be acceptable as collateral by ACH, you, your margin lender, and your broker must sign certain documents. Once the agreements are in place and the margined stock has been lodged with ACH, your broker will be able to execute trades for your account.

Margin Lending Collateral Scheme

The Australian Clearing House has agreed to remove the operational controls on Clearing Participants when lodging encumbered securities. Effectively all positions can be held in the one account that does not need to be set to specific cover.