If you plan to sell options as part of your overall trading strategy, you need to understand how margin requirements work. In this blog, we will look in detail at what your broker will require for you to execute these types of trades.
I base my trade strategies on 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 premium initially and put up margin for the trade.
We know how frustrating it can be to buy a call or put on a stock that moves against you and loses you money. Most of the time, you are paying for time decay which is slowly eating away at your profits each day. As a result, the stock moves, but 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 must all adhere to the minimum required by the Financial Industry Regulatory Authority (FINRA) and the option exchanges where the contract is traded.
You should always check with your broker to know what margin requirements apply to your trading account.
Broker clearance levels for options trading
When you open an account with a broker, you should request options trading authorization. Some brokers will classify options trading clearance within different levels ranging from one to four.
Usually, to buy options you need level one clearance. Â If you plan on selling naked puts (not calls) you more than likely need level two clearance, but the margin is likely much higher.
If you have the necessary experience, I highly recommend you try to obtain level three approval or higher as the margin requirements will be much lower and you will be able to buy and sell options at any time.
How do brokers calculate margin?
We are going to assume for now that you have level three clearance.
Here’s the basic 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 that having margin clearance within your broker does not mean you will be forced 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.
Initial margin is the percentage of a security’s price that an investor is required to have in cash and/or collateral in their account as margin to purchase a security.
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Learn more about margin with our Beginner's Guide to Margin Accounts.
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