How Does Options Margin Work? by www.OptionTradingpedia.com

What is options margin? How does options margin work? Why do I need margin in options trading?

Options Margin - Introduction

Margin has always been a topic stock, futures and options traders have struggled with. The problem with understanding margin is that margin means a different thing for all 3 financial instruments!

That is why stock traders or futures traders usually confuse themselves on what margin means in options trading. Although confusing, understanding what options margin is and how it differs from stock and futures margin is essential for an options trader's complete understanding in executing options strategies, particularly options credit spreads.

This tutorial shall explain what options margin is and the differences between options margin and stock / futures margin.

Options Margin - Content

What is Options Margin?

Margin in equity and index options trading is the amount of cash deposit needed in an options trading broker account when writing options. Writing options means "Shorting" options and happens when Sell To Open orders are used on call or put options. Options margin is required as collateral to ensure the options writer's ability to fulfill the obligations under the options contracts sold.

When you write (short by using Sell To Open orders) call options, you are obligated to sell the underlying stock to the holder of those call options if the options are exercised. If you don't already have those stocks in your account, you will have to buy those stocks from the open market in order to sell to the holder of those call options. In order to ensure that you have the money to buy those stocks from the open market when the assignment happens, the options trading broker will require you to have a certain amount of money in your account as deposit and that's options margin. This is what happens in a Naked Call Write options trading strategy.

Similarly, when you write put options, you obligated under the put options contracts to buy the underlying stock from the holder of those put options if the options are exercised. That is why the options trading broker needs to make sure that you have sufficient money to buy those stocks from the holder of the put options when assigned, hence the need for options margin. This is what happens in a Naked Put Write options trading strategy.

Writers of options are also exposed to unlimited risk and limited profit, which means that the position can lose more and more money the more the underlying stock goes against your expectation. In order to close such losing positions, you would need to Buy To Close those options, that is why options trading brokers also need to make sure you have enough cash in your account to be able to do that.

This is why a lot of beginner options traders would have experienced their brokers returning an error message such as "You need at least $100,000 in your account in order to write uncovered call/put." when attempting to write stock options.

Please note that options margin in this case do not apply to Futures Options or Options on Futures, which has a more sophisticated treatment..

How is Options Margin determined?

Options margin requirement is really the options trading broker's way of lowering the risk they face when allowing their account holders to write options. As the OCC ensures the fulfillment of all options contracts exercised, the responsibility falls on the broker should their account holder be unable to fulfill. This is why all options brokers would have their own way of determining how much options margin is needed for every scenario. The CBOE, Chicago Board of Exchange, also has a set of margin suggestions for all member firms which can be downloaded in pdf format at CBOE's Margin Manual site. However, you should understand the specific margin requirement of your options trading broker as it can be very different from what is suggested by CBOE. Some brokers have slightly more relaxed requirements while some other brokers have slightly stricter ones.

No matter how much margin is required by each broker, margin requirements for stock and index options are always fixed percentage amounts to be applied uniformly in each scenario. This is unlike the variable margin requirement for futures options or options on futures.

Exemption from Options Margin Requirements

There is one scenario which options can be written without margin requirement and that is when there is an alternative collateral in the form of owning a position in the underlying stock or a more in the money long option of the same kind than the one being sold (an options spread).

Owning a Position in the Underlying Stock

Owning a long position in the underlying stock allows you to freely write as many call options at any strike price without involving options margin. This is because the long stock position is a good collateral which can be sold to the holder of the call options at the strike price when the call options are exercised. That is why there are no margin requirements for the Covered Call options trading strategy.

Example : Assuming you own 700 shares of QQQQ at $44. You can Sell To Open 7 contracts of QQQQ call options without any margin.

Owning short position in the underlying stock allows you to freely write as many put options at any strike price without involving options margin as well. Even though margin is not required for writing the put options, margin is necessary for the shorting of the stocks in the first place, which is a different requirement from options margin. This is because the money needed for the buying back of those short stocks would already have been taken into consideration when shorting the stocks, which made sure that the money needed for buying the stocks from the put options holder is available if exercised. That is why there are no margin requirements for the Covered Put options trading strategy.

Example : Assuming you shorted 700 shares of QQQQ at $44. You can Sell To Open 7 contracts of QQQQ put options without any margin.

Margin Requirements for Options Spreads

There are no margin requirements when putting on debit spreads. Debit spreads are spreads where you actually pay money to own. Debit spreads usually involve buying a certain amount of an option and then sell to open further out of the money options of the same kind. In this case, the right to exercise the long option at a more favorable strike price offsets the risk of fulfilling the obligations on a less favorable strike price, erasing the need for options margin. This is what happens in options strategies such as the Bull Call Spread.

Example : Assuming you own 7 contracts of QQQQ's Jan45Call. You can sell to open up to 7 contracts of QQQQ's Jan47Call (or any higher strike price) without any margin.

However, if credit spreads are used, options margin will be required. This is because credit spreads are options positions that consists of shorting more out of the money options than there are in the money options to be secured against or shorting of in the money options while buying out of the money options. In both cases, the long leg in the position helps to reduce the margin requirement of the overall position, making it easier to execute than outright (naked) short call or put options. In this case, options trading brokers usually requires 100% of the difference in strike prices multipled by the number of contracts as options margin.

Difference Between Options Margin and Stock Margin

What confused most stock traders turned options traders is the difference between stock margin and options margin. Stock margin is the ability to buy more stocks than your money allows you to by borrowing from the broker. This is totally different from margin being cash collateral held in the account for the purpose of writing options. In fact, a lot of beginners ask questions like whether options can be bought on margin like stocks. The answer is a resounding NO. Options margin applies only when shorting / writing options. There are no margin involved in buying options at all and there are currently no borrowing facilities for options.

Also read the Differences Between Stocks and Stock Options.

Difference Between Options Margin and Futures Margin

Margin in futures is also totally different from margin in options. Margin in futures trading is similar to margin in options writing in the sense that they are both money that are to be held in the trading account in order to fulfill the obligations under the contracts when things go wrong for the trader. What is different is the fact that there are 2 kinds of margins in futures trading; Initial Margin and Maintenance Margin. Losses resulting from the position are automatically deducted from the initial margin by the end of each trading day and then a top up would be needed as determined by the maintenance margin when the initial margin runs low. This is totally different from options margin as no deductions from the cash held is made at the end of each day even if the position is in a loss.

Also read the Differences Between Futures and Stock Options.

What About SPAN Margin?

SPAN Margin is short for Standardized Portfolio Analysis of Risk margin. This is a margin system for options on futures, which is based on the same need to reduce risk of assignment but not using a fixed percentage for each scenario but based on an extremely sophisticated algorithm which determines the worst case one day risk of an account. This system better ensures performance of contracts and reduces margin requirements for lower risk positions. SPAN margin is currently available for options on futures only and not for equities and index options (true as of Jan 2009).

Questions Regarding Options Margin

"When Is There Margin Requirement in Options Trading?"

"SPAN Margin For Spreads?"

"How To Erase Margin Requirement In a Time Spread?"

Options Margin