Lesson Overview

Reducing Margin Requirements

With larger accounts you'll want to trade slightly more undefined risk trades. These give us the biggest P&L at the end of the year but of course tie up a lot more capital in margin.

Today we'll talk about reducing the margin exposure on selected strategies. This helps not only reduce overall portfolio risk but increase our return on capital which can help dramatically with our overall profit.

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  • Marvin

    Hey Kirk. You mentioned you decrease margin use but also decrease credit taken in by about 10%. Do you recommend buying protection at a strike price that would yield a similar reduction in credit? (In this case the protection was bought at 25 strikes away from the short options. Or should we target the protective legs at that strike price?)

    • Depends on your risk tolerance and account balance. I think generally the more credit you can take in the better but if that means going over your per trade allocation, then I say scale back.

  • AJ

    Super video! Very helpful for converting trades from undefined to defined risk. Thank you!

Show Video Transcript +

In today's video, I want to talk about a couple of ways we can reduce our margin requirements on trades. This is a really good video, not only for people who have larger accounts but if you're trading an IRA account and you want to mimic some of the undefined risk traits that we do here.

Or that anybody does, basically your straddles and strangles and ratio spreads, it's going to be hard to do that because those trades usually require a lot of cash up front for your IRA or your retirement account.

In this video, we're going to talk about some simple ways that you can reduce or cut your margin requirements and also increase your return. Again, with larger accounts, you'll want to trade slightly more undefined risk trades.

These give us the biggest PNL, dollar wise, at the end of the year, but, of course, they tie up a lot of capital margin. Today we'll talk about reducing those market exposures on selected strategies.

This helps not only reduce overall risk in the portfolio, but also increases return on capital which can dramatically help with our overall profit, and again, basically use of funds.

Let's first start with a short straddle directly over the market for SPY. I took this data as of today's date, the time that I'm doing this video, and you can see that the S&P is trading at about 205, so this works out pretty good.

The straddle that's right on the market about two months out, which is about 53 days, March. The 205 straddle, so we're selling the call and the put takes in a total credit of around $925. It's a pretty healthy premium right now [inaudible 00:01:45] pretty decent in these options.

When you look at the total profit, which is 925 versus the buying power, or margin effect, this is what a broker would typically charge you to get into this trade if you just have undefined risk on both sides.

Notice we didn't buy any options, we're naked two options directly over the market, one call and one put. In this case, our broker is going to require that our initial margin is about $4,098.

You can see the amount of credit that we take in of 925, divided by our margin requirement, means that we should make about 22 1/2% return on our capital if everything stays the same and our options expire, completely worthless, out of the money.

You can see there's probably a fairly high probability of success trade because of our break-even points, based on the credit that we receive, are almost $10 out on either end.

You can see our break even point on the lower side is 195.75, on the top side is 214.25. Again we just take the strike price of the straddle and we add or subtract the credit that we receive to get the break even on either side.

What we're going to do now is take the same straddle, the same short strikes, but now we're going to buy the wings, or further-out options, about 25 points out on each side to reduce margin required and increase our return on capital use.

Here's what we did ... again the stock trading at the same price, so it's live market now, we got this data, the market's down a couple of cents. You can see that now we're doing the 205 straddle, which we're selling the 205 calls and the 205 puts.

Instead, what we're going to do is add the 230 calls that are going to be long, so we're going to buy one of the 230 calls, and we're also going to buy one of the 180 puts.

We're going to buy the wings of this strategy, basically create a very wide iron condor that looks like a straddle over the middle, basically an iron butterfly. We have the short strikes the same as what they were, but now we're buying those wings 25 points out to reduce the margin required on the trade.

Because we had to pay a little bit of money to reduce some of that margin, you can see that our credit has been knocked down to about $850. Our max potential profit on this trade is 850.

Now because we don't have any more risk beyond those points at which we bought the options, 230 and 180, the broker doesn't have to cover any of that risk. Our buying power is reduced to 1,655.

That means that our 850 credit divided by 1655, which is the new margin required for the trade, gives us a return on our capital of 51.35%.

You will also notice that the break-even points for this trade have also reduced just a little bit on either side because that credit is a little bit smaller, it's 850 now, and our break even points have come into 196.5 and 213.50.

As you can see, we were able to cut our margin required by nearly 60% and when we did that we only were giving up about 9% off of the initial credit that we received on the short straddle. This spread helped more than double our total return on capital.

The only downside to doing this is that our break-even points are now narrowed based on the reduced credit which means our long term win rate is going to be slightly lower because the stock can move just a little bit outside of that range.

It's not that much, it's about one point, but the stock can move outside of that range and reduce our long-term win rate. It's all about the numbers.

Still, we feel that reducing our margin required and increasing our return on investment per trade for a slightly less favorable win rate long term is a very good trade off.

We reduced our margin by 60% and in doing so we didn't reduce our credit by 60%, we only reduced it by 9%, so it's a great trade and a great way to reduce the capital required in a trade.

The same thought process, of course, and logistics can be applied to similar, undefined or naked trades like strangles and our custom orders that we talk about and ratio spreads.

Make sure that you go in there and play around with the numbers, use the Analyze tab in you broker platform and see what works for different securities. It won't work the same for every security, but the same thought process should go into a place with all of the trades you make.

Again, this is a great strategy for retirement accounts and with IRAs because in those accounts you can't trade undefined risk trades and all of these situations we just went through, with the iron butterfly, adding those wings, that's a defined risk trade and you will be able to do that in your broker account or your IRA account.

I hope you guys enjoy these videos. If you have any comments or questions, please add them below in the show notes and, until next time, happy trading.

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