If you’re feeling confused about the difference between cash and margin requirements for options trading, this video will help explain each to you.
A margin account is a brokerage account in which the broker loans the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash deposited by the investor. Securities purchased in a margin account can be sold at any time, providing that there are no restrictions on selling short or using stop-loss orders.
A cash account is a brokerage account in which the customer must pay the full amount of cash for securities purchased. Customers are not able to use leverage or margin in a cash account.
In general, cash accounts (also your traditional IRA or retirement account) will require that you have the underlying cash available to cover that contract’s risk for every contract you buy or sell.
With margin accounts, the cash or securities already in your account act as collateral for a line of credit that you can take out from your broker to buy or sell more of an underlying option. This reduces your initial capital requirement for most trades which is a good thing but also leaves you vulnerable to overexposure in using too much leverage.
It’s not that leverage is a bad thing because it isn’t. You just need to know how it’s calculated and how much risk you are willing to take for your portfolio size. We highly recommend that you call your broker and discuss their particular differences in calculating margin requirements for different option or stock positions.
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In this video, I want to go over the differences between margin and cash and how those relate to trading because as you start setting up your account, you might have setup or you may want to set up a margin account that you can trade with.
The margin is just a very complicated way of saying that the broker is going to take other securities in your account and use them as collateral to make other trades and it's a great way to reduce the buying power effect or the drawdown in your account to make a trade.
This type of additional leverage also creates a little bit of an issue because then, it leads some traders into trading positions that are way too large for their position or their account size. You just got to be careful as always with leverage.
It works great when it's in our favor, and it also can work exponentially bad against us if we over-leverage our account. On the screen here, I have two different examples. This example up top, this is my margin account.
This is my margin trading account, and we did the same trade in both accounts and set this up here so that you guys could see the differences between them.
And then down below, you can see it’s the same order, it’s just this is my IRA account. Now you have the differences between a cash account which is an IRA or an investment retirement account and a margin account.
You can have cash investment accounts that aren’t retirement accounts, but in most cases when you trade options, you’ll want to open up a margin account because that will allow you to get the smaller buying power reduction for each trade that you do and it just becomes a better use of your capital, you don't have as big or a drawdown.
Let’s go over the example. Up in the top, this is our margin account. In this case, we just sold one Tesla 200 strike put for $1,110. Here you can see that the credit or the max profit we receive if Tesla worked in our favor in this trade then would be $1,110.
It’s important here that we notice that the max risk in this trade, if Tesla does go all the way to zero, is $18,890. This is the risk if Tesla goes to zero. It’s not the real risk. The risk that Tesla goes to zero is minimal, if not, nothing because it can’t be worth zero at this point.
This is the risk of the trade, but because it's in a margin account, we are only required to put up as collateral $3,800. This is our buying power reduction because we’re in a margin account.
What happens is that the broker uses other securities or cash that you already have in your account and collateralizes them against this position. This won’t mean that your only risk is $3,800. That's just what you’re putting up initially to cover the position.
If Tesla starts to move against you, then this margin requirement can go up because the position starts to become more of a losing trade and the broker is going to start requiring that you keep and carry more and more capital in your account.
One of the biggest things that people always have and the misconceptions is that this is the initial investment and this will be the only thing I can lose, and that’s just not the case. You do have the risk that is beyond this, but the broker does not require that you put up that amount of capital upfront.
This is why I always suggest that people have an absolute reserve figure in their account in some form or fashion. This absolute reserve amount is this big chunk of cash that you have in your account.
It can be 40% to 60% of your account that you just sit there because in cases like this if margin were to expand and the broker would require more money, you want to make sure that you have that in your account available to cover that trade. Don’t get too scared about using margin. The margin is a great thing. We just have to understand how it works for our positions.
Alright, down below, you can see this is the same trade, except we did it in our IRA account and set this up in here. You can see the stock is trading at the same amount.
Everything is the same. We’re taking in the same $1,110 credit. Notice in a cash account what you have to do, and this is specifically for IRAs and retirements. You have to cover the cash value of your risk.
In a cash account like a retirement account, the broker doesn't allow you to margin some of your other positions. Notice that our max loss here of $18,890 is the same amount as how much we have to put up to initiate the position.
This means on the other hand like a margin account where margin can expand, in this case, since we’re covering the entire risk of the trade upfront one time, this number $18,890 is all you will have to put up in this position because it's the most that you can lose on this position, everything in.
The broker is not going to require any more to be put up in that position. But now you can clearly see using the two different examples right here why a margin account just gives you a better use of your capital, doesn't tie up as much capital, but also how a margin account can negatively affect you if you over-leverage and over-allocate some of your positions.
Make sure that you read through our allocation guide that we have here at Option Alpha. Go through it in detail, so that you understand what we talk about when we talk about absolute reserves and making proper position sizes because it’s not just enough to understand what margin is.
You have to be smart about how you use it with your trades. As always, if you have any questions on margin or cash accounts, please add them right below this video on the lesson page. Until next time, happy trading!