Roll up your selves traders. We are going to cover options trading margin requirements for naked options and option selling.
If you plan to sell options as part of your overall trading strategy, you need to understand how margin requirements work. In this article we go over in detail what the your broker will require in order for you to execute these types of trades.
Our trading system is based on selling options
After years of losing money buying options consistently, I made the firm decision to only trade strategies based in option selling. This doesn't mean we only sell options; we trade iron condors and credit spreads as well. But each of these strategies allows us to collect option premiums up front and put up margin for the trade.
We know just how frustrating it can be to buy a call or put on a stock that moves exactly how you loses money. Much of the time, you are paying for time decay which is slowly eating away at your profits each day. As a result, the stock move and yet the option expires with little or no value at expiration.
Understanding margin requirements
Just like trading commissions, brokers can have very different margin requirements. However, they all must adhere to the minimum required by the Financial Industry Regulatory Authority (FINRA) and the option exchanges where the contract is trade. For example, Chalres Schwab’s margin requirements are much higher than the industry standard, while thinkorswim offers lower Portfolio Margin for higher account values.
At any rate, you should check the specific requirements of your broker to know exactly what margin standards they apply to your specific account.
Broker clearance levels for trading
When you open your account with a broker, you should request options trading authorization. Some brokers will classify options trading clearance within different levels ranging from 1-4.
Usually to buy options you need the basic level or Level 1 clearance. If you plan on selling naked puts (not calls) you more than likely need Level 2 clearance. But the margin is much higher as you are still seen as a beginning trader by the broker. If you have the necessary experience, I highly recommend you try to obtain Level 3 or higher approval.
The margin requirements will be much lower and you will be able to buy and sell options at anytime.
Sample broker margin schedule
Below is a quick sample margin schedule from our broker thinkorswim. Margin schedules are great to help you quickly calculate and determine if you are going to have enough buying power for a particular position or strategy. (Click to enlarge as always).
How do they calculate margin?
We are going to assume for now that you have Level 3 clearance which allows slightly less margin requirements than lower levels. For those of you who are math wizards, you are going to love this stuff. Everyone else, you are just going to have to take us at our word on these calculations.
Here's the base calculation:
(25% of the underlying stock’s market value + the option ask price – any out-of-the money amount) x 100 (per contract) x the number of contracts
The value of the above equation must be greater than:
* (The option ask price + 10% of the stock’s current trading price) x 100 (per contract) x the number of contracts, or
* The number of contracts x $500 per contract.
If either of these two calculations yield a higher margin amount, then the highest value is used.
We want to point out at this point that having margin clearance within your broker does not mean you will be forced to into a "margin call" should your trade go bad. If you have enough cash or stock holdings within your account to cover the margin requirements, then a trade will not trigger the activation of the margin (borrowing capacity) that is available to you.