What is margin and why is it required on some trades and not others?
Margin is simply the ability to use other securities (or cash) in your account as collateral for separate trades. In its most traditional sense you can buy stock on margin by putting up other stocks as collateral for that new positions should it go bad or by powering part of the cost of the stock from the broker which is also considered buying on margin. When it comes to options, we see margin as a way to put up a smaller amount of capital to hold a short premium strategy like a straddle or strangle. The margin amount is usually always lower than what the cash value of holding that position would be which allows us to use our capital more effectively. Some trades don’t require margin because you are a buyer of options and have to put up cash to buy the options to begin with, so there is no collateral needed outside your initial investment. IRA and retirement accounts mostly do not allow margining so those would require cash funding or backing of all trades.
I’ve heard that margin can expand if a trade goes against you - how much can it rise?
Yes with undefined risk (or naked) trades you’ll put up an initial margin requirement to enter the position. This amount will be based on the loss amount should the underlying stock make a two standard deviation move against your position. Again this initial margin requirement is based on the risk at order entry. If the stock starts to move against you, the broker may increase the margin to cover the new, or additional, risk in trade. Margin can rise as much as 60% when the stock moves against your position. For example, if you sold a strangle and your initial margin was $1,000 and the stock moved against you dramatically the margin might increase to as much as $1,600 for the same position. This said you shouldn’t get too worked up about this because this would only cause a margin call if your initial position is too large to begin with. Since we suggest that you keep the number of these types of trades (undefined risk) down in your portfolio and the trade size small you should never encounter a margin call if you follow our guidelines. Speaking frankly your account should never be so leveraged that you encounter a margin call in your lifetime. If you are ever close, then you need to strongly reconsider how large your position sizes are.
Should I be day trading options or should I create monthly position trades in my account?
While we do want to create a lot of occurrences or trades throughout the year, we should not be day traders with our positions. Day trading options would be entering and exiting trades within the same day, and this type of account churn is not effective or profitable. On the other hand, we should strive to be monthly position traders. As a position trader want to have lots of uncorrelated trades across different industries and sectors each and every month. We still might actively trade each day but the trades we enter wouldn’t be entering and exiting the same position in the same day, rather, we might enter two new positions and exit three current positions each in different securities. Finally, we might stagger and stack trades across different symbols and contract months to help spread the portfolio income out over time.
Are trading naked or undefined risk trades too risky?
No. In efficient markets like we have in the US, risk is relative. Often these types of trades get a bad wrap because people label them as “unlimited loss” trades when that’s not the case. In fact, we can measure risk on trade entry using initial margin requirements from a broker. Additionally, you have to understand that if you have a higher probability of success you’ll have to put up more money to enter the trade. This about a lottery ticket, you have a low probability of success and, therefore, a low amount of money to put up at risk (about $1 per ticket). Now, I suggest anyone with an account size under $20,000 strongly consider not making any naked or undefined risk trades. These trades just take up too much in margin as a percentage of your account balance, and you can do just as well trading with risk defined strategies like credit spreads and iron condors in your smaller account. That said you should not completely avoid making undefined naked trades in your account because these trades have a higher probability of success and a higher profit potential in total dollar terms over the course of many trades. Historically on the Option Alpha live performance page you’ll notice that these types of strategies have always had the highest win rates and the highest total dollar profits over many years of trading. The downside to making these trades is that they do require more capital allocated per position which is why they are better suited for larger accounts.
What are the benefits of opening a margin account vs. an IRA?
The clearest advantage is the ability to trade more types of strategies and to use margin for stock and options trading. This additional leverage does come at the cost of trading in account that doesn’t carry the tax advantages of an IRA. The reality is that either a margin or IRA account can effectively and consistently generate income trading options, and they both have their pros and cons depending on your specific financial goals.