Brokers vary over their rules on margin requirements so opening up a Live Chat session with your current broker and asking them directly is the best way to go about finding this information. However, let’s briefly discuss Fidelity, this being a broker that I have used for quite some time now.
Fidelity has 5 different levels of options trading. Brokers, who are member firms of an exchange, must assess your investment experience, background & cash available before they allow you to delve into ‘risky’ strategies. Each subsequent level includes all the faculties of the prior level. The first allows you to hedge existing stock positions so for example, buying a put to hedge your long equity position or buying a call to hedge your short equity position. The second level allows you to buy naked calls & puts & other ‘covered’ strategies. Any ‘uncovered’ strategies like writing naked calls or putting on spread trades, you must be set at level 4 or 5. Scroll down to the bottom section of their options margin page to see all the details. Fidelity wants to see you maintain cash over $20K in order to be able to write uncovered options positions and depending on your particular strategy there are specific margin requirements to follow.
In my premium member subscriptions, you will soon find several options videos which detail examples of the various strategies you can try out with options & the specific margin requirements to address prior to placing any trade.
For those of you who aren’t premium members, however, we’ll run through a couple examples here to give you the general gist of the margin issues you’ll have to consider before exploring these options trades. The first we’ll take a look at is writing naked calls/puts as this is the most capital intensive strategy you can employ. Again, this post is just to explain margins not the actual strategies. As we expand this particular series, we’ll examine each strategy in detail.
This option to your left is the $90 November 25th Calls on Goldman Sachs (GS). Now, selling calls without a long position or some kind of hedge is considered extremely risky by your broker, in fact, it’s one of the riskiest strategies you could dabble in. It is for these reasons that many brokers want to basically lower their risk in allowing you make the trade. They do this be requiring you to have a minimum cash balance available in your account. Now, let’s take Fidelity for instance. They want to see you have “25% of the underlying stock value, minus the out-of-the-money amount, plus the premium”. Now wtf does this mean?
I sold 10 contracts of this GS Call at a premium of $.68, which means I received $680 dollars for selling that option to someone else. (Remember each contract represents 100 shares of the stock so $.68*100 Shares*10 Contracts)
Since I’m exposed to 1000 shares of Goldman Sachs (GS), they want to see that you have about 25% of the position. The stock is currently trading at around $88, which works out to about $22K in cash needed. (1000 shares * $88/share) Again folks, this is a rough estimate here, each broker works differently some will ask for 35% or even more to sell naked calls. One observation I want to point out, however, is to notice how much capital you must expend to pull in such a minimal gain on the trade. You’re expending AROUND $22K to pull in a MAX profit of $680.In reality, the only players that sell naked calls/puts are the big institutions & hedge funds who program trade with algorithms. We’ll explore these tactics in later installments to this series.
Don’t get scared though!
There are ways to get around these margin requirements by putting on another leg in your options trade. These are called ‘spread’ trades. Depending on whether you have a ‘debit’ or a ‘credit’ spread you can minimize the amount of cash required. So WTF is a spread?
Stay tuned for the next episode of ‘The World of Options’!
Great points, Sang.
Many of the publications I read on trading options speak about writing the calls/puts to be a lower-risk strategy.
However, I’m glad you pointed out the fact that the percent of money you stand to profit compared to the amount you’re risking/tying up, In many ways doesn’t make up for the risk.
Like you said, this strategy requires you to have a seriously large acct.