Free Buying Power: An Underappreciated Asset

Few principles of investing are as misunderstood and underused as is the value of free buying power contained in margin-type accounts. What is buying power? It's what is still available after adjusting for prior security purchases and sales of naked options, or both, which involve margin requirements. For example: A fully paid-up $100,000 equity margin-type account with that same amount of stock value would thus offer up to another $100,000 in maximum buying power. That is twice the account's equity, or $200,000, minus the $100,000 already used to purchase shares. I never recommend buying stock with borrowed money. You would then be subject to paying interest on the money borrowed from your brokerage firm. People who buy on margin are seeking upside leverage. That comes with a well-defined cost, however. Needing to earn between 6.57% and 8.35% just to break even is not a great way to try to make money. Some firms are even more expensive than Schwab in terms of their margin interest costs. If you desire leverage, why not simply sell (also called write) put options on stocks you think will go higher? Selling puts against free buying power does not involve borrowing money. In fact, when you sell options you generate cash to your account. An example of some very profitable put sales on a stock I recommended here last September was with Interface . It was then selling for $6.81 and I loved the shares to double or triple over the coming 18-months. The trades below, shorting TILE's Friday expiration date $7.50 and $10 strike price puts, were really made at the exact prices shown below. The quantities were quite large, at 202 contracts of the $7.50s and 507 contracts of the $10 strike. It took a large equity value to have enough free buying power to stand ready to purchase up to 70,900 (combined) of TILE, if exercised later. As it turned out, though, TILE rose, as expected, and closed at $12.78 on the Friday expiration date. All the options thus expired worthless. Nobody was going to put TILE to anybody else at $7.50 or $10. Why not? They could sell the shares on the open market for well over $12. The graphic below details the actual gains booked upon expiration for the option seller. The ultra-conservative $7.50 puts provided a $33,811 net gain. The $10 puts produced an almost $176,000 profit. How much cash was required to earn the combined gain of $209,613? Absolutely none. The puts were secured by free buying power already available in the account. What is the return on investment (ROI) on that? It is infinite as there was never any money laid out. Skeptics will point out that there was a $448,883 potential purchase involved, even though it never was required. The net gain of $209,613 represented a stunning 46.7% of the theoretical outlay and was achieved over an average time horizon of just six-months. Note, too, that the worst-case, forced purchase prices on the two puts sales were $5.83 and $6.53 per share respectively. Both were extremely favorable compared with TILE's current 52-week range of from $5.88 - $14.34. Not everyone could have handled trade commitments as large as those described. You don't need to trade in that kind of size to make decent money selling options. Here are some smaller naked put sales which also expired on Friday to illustrate that point. All four of the trades used very conservative strike prices with large built-in margins of safety vs. the trade inception prices. In each case the if put prices turned out to be less than half of the expiration day quotes. Using more aggressive (higher) strike prices would have netted much larger gains. Even so, committing to own a total of $25,712 worth of shares, at extremely cheap entry points, still created a $4,080 net gain. That equated to 15.87% of the theoretical exposure and an infinite ROI on what turned out to be a negative cost of capital. Both stocks were terrific holdings over the past six-months. You can see the charts for Cato Corp and Greif . Regular readers of my columns might remember the money earned via large sales of puts on Michael's , which was recently taken private at $22 per share. Puts sold at strikes ranging from $2.50 to $20.00 ended up either cheaply closed or expiring worthless generating a whopping $427,699 combined profit. Using free buying power to meet the margin requirements on selling naked puts gives you upside leverage without the cost of paying margin interest. Well thought out put sales can contribute mightily to total returns. The trick is to identify stocks which are undervalued, and then only sell as many puts as you'd feel comfortable having exercised in a worst-case scenario, based on your individual account equity situation.

Free Buying Power: An Underappreciated Asset

Let's look at this little understood and little used principle of investing, using TILE and MIK as examples.

Columnist Conversation

We should be in for better starting soon.

Stocks Under $10

Two Good Signs -- Especially for Small-Cap Investors

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.