how margin works with options

In short

A friend of mine once told me he thought margin was a free loan from his broker, and I could not blame him. Margin with options is a deposit the broker holds to cover risk, and the rules change with the kind of trade. If you are buying a call or a put, the buyer pays the full price up front and no margin is needed. When someone sells an option, the broker holds cash or other assets as a safeguard against a loss. A spread, where one option offsets another, can need far less held back than a lone short option. Every broker may add its own rules on top of the official minimums, so the account agreement is worth a careful read. That reading belongs before a trade, not after.

The whole of it

What it is

I once watched a neighbor put a deposit on a rented trailer, and the fellow at the counter said the money was not a fee. It was a promise held in trust until the trailer came home in one piece. Margin with options works much the same way.

You have probably heard the word margin used for stock loans. With options, the word covers two related ideas. The first is a margin account, which is a brokerage account that lets an investor borrow from the broker. The second is the margin requirement, which is the cash or securities the broker holds against a trade that could lose more than the investor paid.

Here is the part that trips folks up. When someone buys an option, the most that buyer can lose is the price paid, and that is known on day one. So the broker needs nothing extra. When someone sells, or writes, an option, the loss can be bigger than the money taken in. The broker is left holding the bag if the trade goes wrong and the seller cannot pay. So the broker asks for a deposit first. Simple as that.

How it works

A friend of mine who writes covered calls explained it to me over coffee, and I have remembered it since. A covered call means the seller owns the shares and sells someone the right to buy them at a set price. Because the shares themselves stand behind the promise, the broker does not ask for extra cash on that trade at most firms.

A cash secured put works the same way from the other side. The seller sets aside enough cash to buy the shares if the buyer exercises the option. The cash is the safeguard, so the broker has little to worry about.

The harder case is the naked option, which is a short option with nothing behind it. A naked call can lose without limit, since a stock price has no ceiling. Because of that risk, brokers set strict approval levels, and some will not allow naked selling in a small account at all.

Then there are spreads. A spread pairs a short option with a long option at a different strike price, which is the price written into the contract. The long option caps the loss. So the broker holds back only the worst case loss of the pair, which is far less than for a lone short option.

Several bodies set the baseline. FINRA, the Financial Industry Regulatory Authority, publishes margin rules for its member firms. The Options Clearing Corporation sets margin for its clearing members. The Federal Reserve Board sets the initial margin for stock under Regulation T. A broker can ask for more than these floors, and often does.

Brokers also watch each account every day. If losses push the account value below the maintenance level, the broker issues a margin call. That is a demand to add cash or securities. If the investor does not, the broker may sell positions to fix the shortfall. The broker does not have to ask first.

The numbers, and where to find yours

If you are holding an options account, the first number to find is your approval level. Brokers rank customers by what they may trade, from level one for covered calls up to higher levels for spreads and naked options. Your account agreement or the options page on your broker's site shows your level.

The second number is the margin requirement for a given trade. Many brokers show it on the order ticket before the trade is placed, and some offer a margin calculator. Look for words like buying power effect or margin requirement.

The third group of numbers comes from law and industry rules. The minimum equity for a margin account is the current figure, which the official source publishes each year. The initial margin percent under Regulation T is the current figure, which the official source publishes each year. The pattern day trader equity minimum is the current figure, which the official source publishes each year. For these, read FINRA Rule 4210 and Regulation T at the Federal Reserve Board. The Options Industry Council, run by the Options Clearing Corporation, has plain guides for investors.

One more place to look. Before anyone trades options, the broker must give that customer a copy of Characteristics and Risks of Standardized Options. The Options Clearing Corporation writes that booklet. It is worth the read.

A worked example

Let me tell you about a woman I will call Dana. She is a teacher who owns 100 shares of a company, and she is curious about options but wary of risk. Her broker has approved her for covered calls and spreads.

Dana first thinks about buying a call. The option costs $2.50 a share. One contract covers 100 shares, so the cost is 100 shares at $2.50, which is $250. That $250 is the most she can lose. No margin is required, because the full price is paid up front.

Next she looks at a spread. She would sell a call with a $50 strike and receive $3.00 a share. She would also buy a call with a $55 strike and pay $1.00 a share. Her net credit is $3.00 minus $1.00, which is $2.00 a share. For 100 shares, that is $2.00 times 100, or $200 received.

The two strikes are $5 apart. The gap times 100 shares is $5 times 100, which is $500. That is the most the spread could cost her at expiration, before counting what she took in. The worst case loss is $500 minus the $200 credit, which is $300. Many brokers hold back about that worst case, so $300 is a fair guess at what her account would show set aside. Her own broker may ask for a different figure.

Now picture a naked short call, with only the $50 call sold and nothing behind it. Say the stock jumped to $80. The call would then be worth $30 a share. That is $30 times 100, or $3,000, against the $300 she collected for it, which is the $3.00 a share times 100. The loss on the naked call would be far larger than on the spread, and the spread's loss stops at $300. The spread had a fence around it. The naked call did not.

Where it goes wrong

I have seen smart, careful people get burned here, and it was rarely for lack of brains. They just did not look at the requirement before the trade.

The first slip is assuming the margin number stays put. It does not. The requirement can rise when a stock gets jumpy or when the broker changes its rules, and that can arrive without much warning.

The second slip is treating margin as extra money to spend. It is a deposit held against risk. Money tied up as margin is not free for other uses, and a loss can eat into it fast.

The third slip is forgetting early assignment. A short option can be exercised by the buyer before expiration. A spread that looked safe can turn messy overnight, and the seller may wake up owing shares. This can happen with American style options, which allow exercise at any time.

The fourth is the margin call itself. The broker may sell positions to cover a shortfall, often at a bad moment. An investor can end up owing more than the account held.

Questions to answer before you leave this page

Have you read the options risk booklet from the Options Clearing Corporation that your broker must provide, and did it match what you thought you knew? Do you know your approval level and what it lets you trade? Can you find the margin requirement on the order ticket before you press the button, and do you know what happens to that number if the stock moves against you? Could you cover a margin call in cash without selling something you meant to keep? Do you know whether the option you are selling can be exercised early? And if the worst case happened tomorrow, would you still sleep well tonight?