Margin for short options

In short

A friend of mine once sold an option because the cash it paid looked like free money, and he never thought to ask what the broker would hold back. If you are thinking about selling options, you should know that the broker will freeze part of your account first. That frozen money is called margin. It is not a fee, and it is not a loss. It is a deposit the broker keeps so the trade can be closed out if it turns against the seller. The amount comes from rules set by the exchange, by FINRA, and by your own broker, who may ask for more. Your broker posts its own margin rates, so read them before you place the order. Know that number first.

The whole of it

What it is

I once watched a neighbor lend his ladder to a man he barely knew, and the first thing he asked for was a set of car keys to hold until it came back. Margin on a short option works about like that. When you sell an option, you take cash now and accept a duty later. A call seller may have to deliver shares. A put seller may have to buy shares at a set price. The broker does not want to chase anyone for money after a bad week, so it holds assets in the account as a cushion.

Short means you sold the contract first. Margin here means the money or securities held back to cover that duty. It is not a loan in the usual sense, though some brokers also lend against the account, and that is a separate matter. Each contract usually covers 100 shares, so a price of $2.00 on the screen means $200 in premium. Premium is the cash the buyer pays the seller.

Some sales need no margin hold beyond the trade itself. A covered call is one where the seller already owns the 100 shares. The shares themselves are the cover. A cash secured put is one where the seller sets aside enough cash to buy the shares. In both cases the broker has what it needs. The trouble starts with uncovered, or naked, sales, where nothing backs the promise.

How it works

If you are holding an account that allows short options, your broker has already sorted you into an approval level. Selling uncovered options takes the highest level, and the broker must approve the account for it. The broker will ask about your income, your net worth, and your experience. Some will say no. That is their right, and it is often a kindness.

Once approved, the margin hold is set by a formula. The exchange rules, found in the Cboe rulebook, give the standard method for equity options. For an uncovered short equity option, the common method takes the greater of two figures. The first is a percent of the stock price, plus the premium, less any amount the option is out of the money. The second is a smaller percent of the stock price, plus the premium. The Cboe rules and your broker's margin page give the exact percents. Out of the money means the option has no built in value yet, because the stock price sits on the wrong side of the strike.

FINRA Rule 4210 sets the floor for margin at member firms. A broker can ask for more than that floor, and many do. Short options on a broad index often carry a different percent than those on a single stock. Short options on futures follow still other rules.

The hold changes every day. If the stock moves against the seller, the margin grows. If it moves the other way, the margin shrinks. That is why a seller can wake up to a margin call. A margin call is a demand from the broker for more money or securities. The account agreement lets the broker sell positions without asking first if the call goes unmet. Read that line twice.

Spreads change the picture. A spread pairs a short option with a long one on the same stock. The long leg caps the worst case. So the broker holds only the gap between the two strikes, less the net premium taken in. A margin hold on a spread is far smaller than on a naked sale, because the risk has a ceiling.

Some brokers also offer portfolio margin. It sizes the hold by testing the whole account against price swings. It can cut the hold for hedged positions. FINRA Rule 4210 sets the account minimums for it, and the broker must approve the account. It can also raise the hold fast when markets get rough.

The numbers, and where to find yours

Plenty of folks assume the numbers are one fixed thing. They are not. The percents in the exchange formula are written into the Cboe rules, and your broker may layer its own on top. The minimum equity a margin account must hold is set by FINRA Rule 4210, and the Federal Reserve's Regulation T sets the initial credit limit for securities purchases. Regulation T does not set the hold on every short option, but it frames the rest of the margin system. The initial margin percent under Regulation T is the current figure, which the official source publishes each year. The minimum equity for a pattern day trading account is the current figure, which the official source publishes each year.

To find your own figure, open your broker's margin requirements page, or look for the margin calculator inside the trading platform. Many brokers show the hold before you send the order. The Options Clearing Corporation also publishes the Options Disclosure Document, which every buyer and seller of listed options should read. It is titled Characteristics and Risks of Standardized Options. It is free, and it explains the duties a seller takes on.

A worked example

Let me tell you about a woman named Marlene, who sells one put on a stock trading at $50. She picks a strike of $45 and takes in $1.50 a share, which is $150 for the contract. The put is $5 out of the money, since $50 less $45 is $5.

For a simple teaching figure, say her broker uses 20 percent of the stock price, plus the premium, less the out of the money amount. Twenty percent of $50 is $10. Add the premium of $1.50 a share, and the sum is $11.50. Subtract the $5 out of the money amount, and the result is $6.50 a share. For 100 shares, that is $650.

Now the second test, using 10 percent of the strike. Ten percent of $45 is $4.50. Add the premium of $1.50 and the sum is $6.00 a share. For 100 shares, that is $600. The broker takes the larger figure, so Marlene's hold is $650.

Those percents are only for teaching. Her real broker may use different ones, so she checks the posted rate first.

Compare her cash secured way. To sell the same put with full cash behind it, she would set aside the strike times 100, which is $45 times 100, or $4,500. She keeps the $150 premium, so her net cash outlay is $4,350. The naked method ties up $650, while the cash secured method ties up $4,500. The first uses less money. It also leaves her far more exposed if the stock falls hard, because the broker is not holding enough to buy the shares.

Say the stock drops to $40. The put is now $5 in the money, so it is worth at least $5 a share, or $500 a contract. Marlene took in $150, so her paper loss is $500 less $150, which is $350. The broker's hold also grows, since the out of the money cushion is gone. At $40 with a $45 strike, the first test is 20 percent of $40, which is $8, plus the $5 intrinsic value as the premium now is near $5, giving about $13 a share, or $1,300. So her hold climbed from $650 to about $1,300 while her loss grew. If her account cannot cover the gap, a margin call follows.

Where it goes wrong

I have watched good people trip on this, and it is rarely from carelessness. It comes from picturing the hold as a fixed fee. The hold moves with the stock, so a quiet position can turn costly in a day or two.

Another trap is a thin account. A seller who uses nearly all the available margin has no room when prices jump. A margin call then forces the broker to act, and the broker's choice of what to sell may not be the seller's choice. Leave room.

A third trap is early assignment. The buyer of an American style option may exercise it before it expires. The seller must then deliver or buy the shares right away, and the margin need can change overnight. It tends to happen near a dividend date, so that date is worth knowing.

A fourth is mixing up the broker's number with the exchange's number. The exchange sets a floor. Your broker can set a higher bar and change it without much warning, especially around earnings or in wild markets. The account agreement gives the broker that right.

Last, a premium that looks fat often signals real risk. Sellers collect more when the market expects a big move. The cash feels good. The duty behind it is the same size either way. Respect it.

Questions to answer before you leave this page

Have you read your broker's margin page and your account agreement, and do you know whether your account is approved for uncovered options? Do you know what your broker holds for the exact trade you have in mind, and how much that hold would grow if the stock moved against you by 10 percent? How much cash or other value would you have left over after that hold, and could you add more within a day if the broker asked? Have you read the Options Disclosure Document from the Options Clearing Corporation, and do you understand what assignment means for a seller? If the stock gapped far past your strike overnight, could you meet the call without selling things you meant to keep? And finally, do you know what the broker may do with your account if you cannot?