The 5% Rule for Options; A distant memory? Enron as the Model for the Global Economy

Twenty years ago, folks when they opened a stock market account, chose a cash account, called a type1 account, or a margin account, a type2 account. As the name suggests, the securities in the cash account were paid for, and the ones in the margin account were "Margined" or they may or may not have some of the equity in the account be borrowed funds. The rules of the stock exchange were quite specific on the opening margin amount, and the maintanance amount, respectively 50% and 20%. To use a simple example, if one had $3000 one could buy $6000 worth of stock. Then if the stock declined, the minimum amount of equity one would have to have on a daily basis was 20%.

The other element was that on the very top of each account opened was a PURPOSE. The purpose had to mirror the type of account. Normally, retired folks had cash accounts. They did not trade on options, or use margin. It was the duty of the manager of the office to supervise each broker to see that the details of each account matched the purpose on top.

If a person who had been quite conservative and was 60 for example, would want to simply dabble in options, a separate account would have to be opened, and there was a 5% Rule. If the investor was to lose everything in the option account----this "TOTAL" loss could not exceed 5% of the total liquid net worth of the investor, and this may have been 5% of the liquid net worth that the firm could verify or had under management.

Here is a story to illustrate the point. One day one of my old school chums called up and asked whether I could go for coffee. He was a very successful lawyer. I was a stockbroker at the time. After ordering a coffee, as usual in the Minnesota Viking mug with the extra sugar and whipped cream, I asked how things were going.

He said, "Not too well. One of my major clients just lost a million dollars." It seems that during a market swing, he had been invested in options and had simply lost his entire account at a major brokerage house in St. Paul.

I replied, "That simply cannot be so."

Then I explained the 5% Rule. After explaining that when each account on Wall Street is opened, the client is given a booklet with the rules in it, by law, and the 5% rule was in it. The broker in this firm had broken the rule and the investor should get his money back and be made whole for the excess over 5%.

After the coffee, he smiled. "I'll be happy to pick up the check", he said.

Later I passed him in the street and he laughed and said that the client had been made whole.

Over the past 20 plus years, with the blurring of cash and margin accounts, and with the relaxation of the barrier between banks and brokers, and with the global marketplace and the absence of supervision over both products and the brokers that sell them, not only the individual investor is at risk by complicated products that the banks and the investors and the regulators do not understand...entire nations are at risk. That is the lesson of the recent trader losing 7 Billion in the French Bank.