As the old saying goes, the market can remain irrational longer than you can remain solvent.
This article was originally written by Chuck Saletta of The Motley Fool
From its close on Feb. 19 to its close on March 12, the S&P 500 (NYSEARCA: VOO) fell more than 26%, a huge decline in less than a month. Like many investors who had been using options in a margin account, I faced a margin call during that precipitous decline and was forced to liquidate positions to satisfy that call.
Note that despite facing that margin call, I never actually borrowed money from my broker. I just had margin available and usable from a purchasing power perspective in the event some of my options got exercised against me. It didn’t matter to my broker, though, who only saw the margin math, rather than the cash and investment-grade bonds that were also in that account and hadn’t seen their values evaporate.
Unfortunately, my experience during that margin call revealed some very ugly realities about how Wall Street really works, particularly when it comes to retail investors. In the hopes of sparing others the same experience I faced, here are five ugly lessons from that nasty margin call.
1. Your broker has the right to immediately change margin requirements
While there are regulations that set limits on the level of margin an investor can take out, brokers also have the right to require higher equity/less margin than the regulated limits. They are also free to adjust those terms as they see fit.
In a classic case of closing the barn door after the horses have escaped, often, they’ll ratchet up margin requirements after a stock falls precipitously. Ignoring for a moment the warped Wall Street logic that believes a stock is riskier at $10 than the same stock at $30, that ratcheting up of margin requirements has real consequences for investors.
In particular, that move can double — potentially even quadruple — the amount of money an investor has to have in available equity to maintain a position, just as that position is falling. Since the broker can make that determination at will, an investor leaning on margin at all faces the very real risk that the broker will take away that margin at any time for any reason, without real notice. That move — by a panicking broker — can force a margin call or make an otherwise mild one much worse.
2. Your broker has the right to immediately liquidate you when you face a call
In ordinary market, your broker may give you a few days to satisfy a margin call. It doesn’t have to, however, and if it gets particularly nervous, it can accelerate that timeline to be immediate. If the call is immediately due, then the broker has the right to liquidate your investments at its discretion to get you in compliance with its margin limits.
When you have time to satisfy a margin call on your own, you have many more tools at your disposal. You can deposit cash. You can liquidate a position you were getting ready to get out of anyway. If you’re using options, you can often roll your position out and potentially change your strike price in such a way that you improve your equity position enough to satisfy the margin call. If you have enough time, you may even be able to wait out a mild margin call by hoping the market moves in your direction.
When the broker decides you need to liquidate immediately, however, and the broker itself makes the call on what to liquidate, all those tools go out the window. You’re at your broker’s mercy, and all the broker really cares about is making the margin call go away, not about what is ultimately in your best interest.
3. Margin math on options is at least partially based on fear
When you sell an option, you receive immediate cash, but you take on an obligation regarding the underlying stock. For instance, if you sell a $50 put option against a stock for $3, you pocket that $3 but pick up the obligation to buy the stock at $50. In your broker’s accounting, however, your $3 in cash is your asset, and both the put option itself that you’re short and the obligation to buy the stock at $50 are your liabilities.
If the stock falls, the put option itself gets more valuable — and your short position on the option becomes an even bigger liability for you. That holds true even though your real economic obligation remains consistent, to buy the stock at $50. To add to that, options pricing is partially based on volatility, and the more fear there is in the market, the more volatility. Higher volatility means higher options pricing, which makes a short options position look even worse in volatile times.
Said differently, if you sold a put option for $3 that later became worth $5 due to increasing volatility, your broker would report your equity as $2 lower than it did previously, just because of that volatility. That makes your equity and margin position look worse because of nothing more than fear, despite having the exact same economic liability you had before.
4. The investment grade bond market is a mile wide and an inch deep
As recently mentioned, I own investment-grade bonds in the same account I use for options. A key reason is to tamp down on overall volatility in that account, but another reason I bought those bonds was to provide a relief valve if the stock and options market turned sour. I figured that if the worst came to pass, I could sell those bonds to raise cash and satisfy any big margin call that might hit.
For at least a little while, that looked like it would work, as bond yields plummeted (and bond prices rose) as stocks started tumbling. It looked like it would work, that is, until I actually went and tried to sell those bonds to help cover that margin call.
Even with all three prior lessons working against me, I had enough in bonds that I should have been able to satisfy that margin call without being forced to close my options positions in the frothy market. Instead, I found out the hard way that it’s easier to buy a bond than it is to sell one.
In several cases, I couldn’t get any bids at all to buy my investment-grade bonds. In others, the only bid I could get was at a ridiculously low price — nearly 30% off — compared to recent trades on the exact same bond. While I was able to sell some of my bond holdings to help reduce that margin call, I was unable to sell enough bonds to completely satisfy it.
5. Once you’re out, you’re out
Despite what I thought would have been sufficient planning to protect myself from a forced liquidation during a margin call, those first four lessons made it clear that it wasn’t enough. Ultimately, I was forced to close positions because of that margin call that I believe would have been decent long term investments. Thanks to the steps I had taken, it was less awful than it could have been, but it still hurts to have been forced to sell largely because the market and my broker panicked and made a bad situation worse.
As if to add insult to injury, the market staged a huge comeback in the last half hour of trading on March 13, the very same day I was forced to liquidate. While I didn’t completely miss out on that rally, I ultimately could have liquidated less and participated more in it. Being forced out of my positions, however, I didn’t have that option and instead had to be satisfied with a smaller share of the rebound.
Lessons learned, actions changing
Although I’ve gotten through this particular margin call, I have to act as though the market will continue to be volatile and could even fall further. If I’m going to continue to use options in a margin account, I need to boost my precautions beyond simply buying bonds in the same account with the excess returns I may receive when times are good.
I don’t have all the answers yet, but this experience means something will have to change. Key changes I’m considering include:
- Changing my asset allocation plan and holding those bonds in a different, non-margin account at the same broker. That way, in the event of another nasty margin call, I’ll be able to transfer those assets into the account to boost its equity without having to try to sell bonds in a seized up market.
- Having a higher personal minimum purchasing power requirement after opening a new options position. That way, I’ll be using less of my available margin when times are good and give myself more room to maneuver the next time the market and my broker panic.
- Closing out options positions when they’re near full potential profit instead of waiting until they’re near their expiration date. Options remain very volatile investments, and a nearly full profit that you can actually receive is certainly better than not getting anything at all because the market turned sour before expiration.
Of course, an even smarter idea would probably be to completely avoid margin altogether. That way, nothing — not even a panicked broker — could force a sale just because the market is down.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.
Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.