Understanding Options Trading Margin Requirements For Naked Options

Get ready traders – in this blog we are going to look at understanding the trading margin requirements for naked options trading 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 blog, we will look in detail at what your broker will require for you to execute these types of trades.

Our Trading System Is Based On Selling Options

I base my trade strategies 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 against you and loses you 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 moves 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 must all adhere to the minimum required by the Financial Industry Regulatory Authority (FINRA) and the option exchanges where the contract is traded.

For example, Charles 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 which margin standards they will apply to your particular type of trading account.

Broker Clearance Levels For Options 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 one to four.

Usually, to buy options you need the basic level or level one clearance.  If you plan on selling naked puts (not calls) you more than likely need level two clearance. But the margin is much higher as you are still seen as a beginner trader by the broker. If you have the necessary experience, I highly recommend you try to obtain level three or higher approval as the margin requirements will be much lower and you will be able to buy and sell options at any time.

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).

How Do Brokers Calculate Margin?

We are going to assume for now that you have level three clearance which has slightly lower 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 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 at this point 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.

Ways To Reduce Your Margin

There are some strategies you can take to reduce your margin and we have created a short video looking at a couple of ways we can reduce our margin requirements on trades.

This is an excellent 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.

We look at 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.

In the video, we 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 use of funds.

We also have a second video which shows you how to free up more margin and cash to help you continue trading regularly.

If you have any other questions about understanding margin requirements for options trading, please feel free to add the into the comment box below, and we will answer them for you.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.