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Board: Fool One Central

Author: Cascell

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Hi everyone,

My name is Steven and I utilise margin to buy stocks. It feels so good to be able to admit that.

For years I have been an outcast unwilling and unable to admit my habit – indeed in investing circles a heroin addiction is probably more socially acceptable. On a scale, I would imagine that Motley Fool’s Morgan Housel would rate margin investing somewhere between cannibalism and eloping with your daughter-in-law.

As it happens, Mr Housel quite recently wrote an excellent article on the dangers of margin investing (btw Morgan – if you are reading this I really enjoy your articles – chicken soup for the investing soul). I have to admit however that I utilise margin as part of my portfolio, albeit not at its fullest extent, because I believe it adds significantly to my returns over the long-term. While the various articles I read have many fair and valid points it is my belief that they often do not represent the full story and are based on modes of thinking that are better applied to a conventional portfolio rather than a leveraged one. I have been reluctant until now to write a dissenting view – mainly because we have had such a sustained bull market that there hasn’t been a real test of my beliefs until the last month or so (I detail below why a 10% correction is just as severe as a 20% one in terms of how I manage my portfolio).

According to the articles I have read in the various media outlets over the last few days, by the close of business Tuesday I should have been a quivering wreck. I shouldn’t have been able to sleep – and when what little sleep I did get should have been accompanied by snuggling in close to a delux bottle of gin. Meanwhile, my friendly broker should have been merrily clicking “sell” on all my positions on my behalf. But none of this happened.

Certainly, with regard to timing, the correction that occurred over the last week or so could not have been worse – not only did everything really kick off on an expiration Friday, but also when the markets opened on Friday I was boarding a plane to a destination with limited internet access from that point on through to the following Tuesday. I could get enough of a connection to see the markets plunging but not enough to actually log-in to my account and get a handle on the situation. Thanks for that one Investing Gods – remind me that I owe you a kick in the nether regions should we ever meet. That being said, while I wasn’t real excited about the situation, I did not have the dreaded margin call and I actually slept quite well. More importantly, since my return on Tuesday I have been able to add to my portfolio such that when we eventually return to previous highs my investment portfolio will be worth considerably more than it was before the Chinese markets had their wee panic (be that in 6months or 5years).

So why was there a disconnect between my experience and what was supposed to happen?

It is all about risk, or more accurately, how you define risk. The traditional approach is to define risk as having two aspects.

Firstly there is the risk that is specific to an individual company – that being the risk that a specific company performs poorly - perhaps it fails to execute on its business plan, maybe its market shrinks, maybe a competitor “builds a better mousetrap” or perhaps even just Mr Market decides he doesn’t like that stock anymore. Think Sodastream, Lumber Liquidators, Caeserstone, Westport etc. The proposed solution for this is to hold a diversified portfolio – by having a number of positions the poor performers should be matched by the great performers and everything should average out. Average out? How Inspirational.

The second aspect of risk is that which relates to the market (or industry) as a whole. When the whole market corrects then so to do all the individual companies that make up that market to a greater or lesser extent. It is this risk that is touted as the risk that needs to be managed, as it can’t be diversified away easily without adding additional asset classes like commodities or bonds. To help with this some bright sparks came up with Betas but lets not go there – I haven’t had my morning coffee yet. The point is then made that if you just are patient with a a few months (or years) the value of your holdings should return to their previous levels.

The issue I have is that if you use leverage in your portfolio with this risk paradigm the first aspect will slaughter your portfolio and the second aspect will Slaughter your portfolio. The reason for this is that when you use leverage the total equity in your portfolio is completely disconnected from the underlying volatility of the market – major swings in the prices of just a few of your holdings has a magnified effect on your equity whether it be diversified or not. This is what leads to margin calls and forced selling at the worst possible time.

Allow me to introduce a new definition of risk:

Total Risk = Value of All the Stocks You Own + Strike Value of stocks you are obligated to buy (via written puts) – Strike value of any puts you own.

That’s it. Period. I am a simple man.

If you own 100 shares of Amazon at £520 each and 100 shares of Apple at $105 then your total risk is $62,500. It makes no difference if you bought those stocks with $62500 in cash or whether you only had to put up 15% of the money, 50% of the money or whatever level of leverage your brokers has granted you. Similarly if Protolab is trading at $72 and you have sold a $70put then your total risk is $7000 (minus whatever you collected in premium). One argument I hear for selling naked puts that really drives me bonkers is this: “I am selling a $70 put in companyXYZ because I am happy to own the stock at $70 so it doesn’t matter if the stock drops below this”. Really? – I had a……discussion……once with someone on the WPRT board regarding this topic a couple of years ago. I stated that selling naked puts was risky. This person countered that they were happy to own the stock at $28. Incidentally if this person happens to be reading this post I am more than happy to sell them as much WPRT at $28 per share as they would like (I think it is trading now at around the $3.50 mark).

Bugbears aside, if you are going to leverage your portfolio safely you need, I believe, to accept the above as your definition of risk and manage to it accordingly.

How? Two ways:

1. If I owned a 100 shares of Apple at $105 and 100 shares of AMZN at $520, I can guarantee you I would also own a put that would allow me to sell my Apple shares at around $95 and a put that would allow me to sell my AMZN shares at around $470 (basically 10% below their current prices give or take). With this in mind now my total risk is the following:
- Apple: Risk = ($105 current price – $95 right to sell) x100 shares = $1000
- Amazon: Risk = (520-470)*100 = $5000
- Total Risk : $6000.
That’s it. The total amount I can possibly “lose” regardless of whether the market drops by 10, 20 or 30% is $6000. To be honest, if Apple drops to say $85 I would probably still keep my Apple shares – assuming I felt that my valuation of the company still held true (I am after all a fundamental investor). Instead I would probably sell the put for cash, buy a new lower put and maybe buy some more shares in Apple if I felt strongly about it. The choice is mine. The point however is that now I have an exact calculation for my risk I can therefore manage the level of margin I utilise more accurately and most importantly accurately calculate the level of margin I can safely utilise while still allowing me an adequate margin of safety during a protracted market correction. Similarly if I did sell a $70 put in PRLB I would almost certainly simultaneously buy a $65 put to reduce my risk. Yes the amount of premium I collect is less but my risk is now only $500 instead of $7000 – this means my returns in percentage terms is much, much better.

The downside of this is of course that you have to pay to buy all of these puts. That’s just the cost of doing business I’m afraid. To counter this I often have a number of income positions to offset this expense (and yes I manage the risk on those as well).**

2. I utilise options to hedge my entire portfolio for a correction in the market. The purpose behind this is to generate cash during a market correction so that I can buy more shares of the companies I love at deeply discounted prices. If you are interested, I use calendar spreads for this as the dynamics of option pricing really help this sort of spread during a market crash. If you are interested in knowing why this is the case let me know and I’ll write a specific post discussing this.

So in summary, am I saying that you should utilise margin? No not at all – my style of investing relies heavily on using options as hedges and I feel that I have developed the skills over time to manage this (ask me again in 10years however). What I am saying however is that there is value in always looking at how much total risk you have on the table even in an unleveraged portfolio. I see occassioanly on the boards posts a situation where someone is worried that a single holding has grown to a size that it is dominating their portfolio - a nice problem to have but maybe there is an argument in protecting the downside risk of some of your larger holdings or even using options hedge the risk of your entire portfolio?


** In case you are wondering, yes for record keeping purposes, I do add the cost of any puts to the purchase price of my shares. 

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