Transcript:

In this lecture, I want to show you how you can reduce margin requirements. This is important both if

you are actually trading on margin, or if you are per se an IRA account and you haven't got that

opportunity.

The larger your account is, the more easy it is, in a sense, to trade on margin. When is that really a

factor? It's particularly a factor for strategies with an undefined risk, so unlimited open-ended risk

downwards. Now those strategies in the long run, if the high probability, are actually very profitable.

So it's not that I discourage trading them, but when your portfolio is of a certain size or you are not

able to use margin, then it might not be the greatest idea. Or, it simply might not be possible for you to

do it.

So that's what I want to show you in this one here. What we have set up here is a simple straddle with

an undefined loss. If you like charts and pictures like me, it looks like this; you lose money unlimited if

it goes below 428, and above 451 we also have an unlimited loss. Pretty wide distance between the

two break-even points, so you'd think that you have a pretty good chance of making money. This

could be set up as a very profitable, high probability trade.

Now the important thing to see here is: We've taken in on this trade $1,159 credit. That's lovely, right?

Money upfront, that's just the way we like it, but...

But, but, but, the buying power effect of this is $8,267. So that's how it impacts our margin, because

I'm doing this in a margin paper account. This could become higher. So the more your share price

moves towards one of your break-evens or even beyond it, your buying power effect and the amount

of margin it eats up is going to increase, and that's always important to appreciate.

Now, what can we do with this? Well, there is a simple thing we can do with this and that is we can

make it limited. So we can clip its wings basically, we can do something like this so that... Maybe I

should use a red pen to make more sense here. So we can do something like that and just limit it so it

will go like that and then it'll be limited, ideally, broadly speaking, on the same level.

So let's take the 500 line here roughly. So it'll look like that, and you're familiar with those I think. We're

basically clipping its wings on the way down.

How do we do that? Well, we basically buy the wings, and that does two things. It reduces margin and

it can actually therefore also increase the return on our capital, because this trade up here is using up

$8,300 of capital. So okay, even if it makes that 1,159 profit; that is that's about a 14% return. So this

here is a 14% return on capital. The capital part is important.

Now how do we do that? Well, we... So the original trade, let me show you here... So the original trade

is this, right. This is the original, and then this here is the adjustment. So we buy a put above the

previous strike prices and we buy a call below it, and you can play with these, see how far you want to

put them out. It depends all on probabilities and pricing, what makes sense the most.

Now, in this example it does have a fairly serious impact on our cost; it's now actually costing us

money. So it's wiped out our credit, but it has reduced our buying power to just 1,359. So we are still

having to put up that 1,300 here, plus the 1,300 over there. So call that 2,600, and what's our

maximum gain on this? Well, let me pull it up again, one second. Put it up again here, I have it open

right here.

So say... Alright, I'd already closed it. Okay.

So we're going to we have to guess this one here slightly, but we can see it on the chart. It says

somewhere between $200 and $400 is probably a realistic profit zone here. So if we take that, say we

call it $300... Maybe let's call it $400, let's be generous. So $400 over our 1,359. That's a 29 percent

return on the buying power effect over here. Which has taken into account already the cost of our

premiums here. So we are now having... So now a $400 profit... Is 29 percent return on capital

employed.

So I think you can start to see that even though we've spent more money on setting up the trade in

premiums, we've clipped our downside. By clipping our downside we have substantially reduced the

buying power effect of this; the margin that we eat up, and therefore this is quite positive.

So you can mess with these trades, these open-ended risk trades just like this, just like the straddle.

By clipping it, yes, initially it's going to cost you a bit more. It's not always going to cost you as much

as in the example I pulled up here. This is a fairly random selection of dates I picked here for this SPY

example. But, it can actually make your real return on your capital employed bigger, even though the

nominal profit might be a little bit smaller.

So I wanted to explain this and show you an example here so you can see; even with a smaller

portfolio, you can still do these trades. You just limit your downside and therefore you limit the

amount of cash it's going to eat up. Whether that's margin or whether that's your cash, either way, it's

going to impact that. By doing this we have more than doubled our return on capital employed, which

is a pretty good outcome, I would say.

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