One of the challenges of learning to trade options is understanding the benefits and risk of using options margin. Actually, there are a number of different types of margin used for stocks, options, and futures, so it can get confusing very quickly. In this write-up, I’ll talk through the various types of margin that are commonly used, the concepts behind them, followed by the benefits and risks of their use.
Defining Margin
Margin is a practice that allows traders to buy and sell stocks, options, and futures using less capital than the total risk of the trade. Perhaps a trader with $100,000 in an account is allowed to trade a security that has a risk of $200,000.
Why would a broker allow a trader to do this? Because the broker knows that it is probable that the trade will not lose more than the amount in the account, and if it gets close, the broker will force the trader to provide more capital or close the position before the account goes to a negative value. In some situations, the broker considers the extra capital a loan to the trader, and charges interest.
Why would a trader want to do this? Because there is the potential for a better return on capital if trade is profitable and the trader only has to put up a fraction of the capital at risk. However, margin adds risk, often substantially, so it is important to understand what the downside is to having extra leverage in trading.
Let’s go through the major types of margin that are frequently used by traders. Not all types of margin are available to individual traders based on account type, experience, and account values.
Stock Margin
Traders with experience trading stock are likely familiar with margin usage in a stock account. A typical margin agreement is that the value of an account can be as low as 50% of the value of stock in an account. So, an account with a $10,000 balance would be able to buy up to $20,000 in stock. If the $20,000 in stock goes up 10%, the trader makes $2,000 or 20% of the account value, and the account would now have $12,000 in value. The trader could even then buy more stock since the $12,000 account balance is more than 50% of the $22,000 stock value.
On the negative side, if the $20,000 in stock dropped by 10% to $18,000, the trader would have two problems. First, the account value would drop to $8,000, a 20% loss. Secondly, the account owner would be over-margined, as the account value of $8,000 is less than 50% of the $18,000 stock value. The broker would require the account owner to either provide $1,000 additional cash to bring the account balance up to $9,000 (50% of the $18,000 stock value) or sell some of the stock to get the stock value low enough that the account balance is more than 50% of the stock value. This situation is considered a “margin call.” If the trader doesn’t act to correct the situation, the brokerage will liquidate whatever stock positions that it feels are appropriate to get the margin requirements in line. Often this means selling at a market low, the worst possible time.
To avoid margin calls on stocks, account owners need to allow some buffer between their stock values and their margin limit. That way the account can tolerate moves up and down without getting into danger of margin call at the worst possible time. Of course, there are other things a stock owner can do, like diversifying account holdings with stocks that have low correlation to each other so that it is less likely that a single stock dropping in value will impact the total portfolio enough to put the account at risk.
It is important to know that buying stock on margin isn’t free. The broker will usually charge interest on the amount of margin being used, so if the stock bought on margin doesn’t change in price, it is losing the owner money because of margin interest.
And finally, stock margin often doesn’t mix with option margin. In many accounts, an owner can use one or more of the forms of option margin we will discuss shortly, or stock margin, but not both. Permissions vary by broker and by account type.
Non-margin Option Transactions
In my write-up on levels of risk, I discuss how brokers grant trading permissions based on different levels of risk. These levels of risk also apply to types of margin. The two lowest option permission levels don’t require margin because the option position can’t lose more than the amount of buying power required for the trade. Let’s quickly review each of these levels and their capital requirements.
Level 0- Covered Calls and Cash Secured Puts: For these trades, the position has the entire possible loss covered by stock or cash, even though the likelihood of a total loss is virtually impossible. In either case a total loss would require the stock going to zero value. For example, if a trader had 100 shares of stock trading at $200 per share, and sold a call for $5, the position would make money at expiration as long as the stock was over $195 per share at expiration. In any case, the position would require $19,500 capital. Likewise, if a trader sold a $196 cash secured put for $1 on the same stock, the position would also require $19,500 capital. Because either type of position is covered or cash secured, margin doesn’t apply.
Level 1- Buying options: For traders buying options, the risk is that the option expires worthless for a total loss. Either the option has value at expiration or it doesn’t. The account owner needs to have the amount of the premium required to buy the option, and there is no margin available for simply buying options outright.
Spread Options Margin
For traders that trade options spreads- buying an option and selling an option in the same underlying at a different strike price or expiration, there is the possibility that the short/sold option could be assigned and the account owner will be forced to buy the underlying security for potentially far more cash than the value of the account. Margin is required for this situation, and the broker buys the stock and shows a negative cash balance in the account. The account owner then can either sell the assigned stock, exercise the long/purchased option, or sell both the shares and the long option together to settle up the account. This form of margin applies to traders approved for Level 2 options permission without Level 3 permission. A common usage is in IRA accounts approved for options- this is the highest level of option risk allowed in IRAs currently.
Spread trades have defined risk, so the amount at risk is determined by the gap in strike prices between the short and long options. Generally, traders can’t enter trades that have more defined risk than there is capital. For example, a trader with a $5000 account could sell at $50 wide spread, but not a $75 wide spread unless they collected over $25 premium.
Because risk is defined at entry of a spread trade, the risk doesn’t change because the maximum loss doesn’t change. And since the risk doesn’t change, the margin requirements don’t change. In fact for spread trades, margin is only used to pay for shares that are assigned from short options. So the only type of margin call that can happen is that the account owner will need to sell assigned shares to get the cash balance of the account positive in the event of assignment.
Margin for Naked Options
Level 3 option permissions allow traders to sell options naked, generally using margin. When selling a naked put, a trader using options margin won’t need the entire notional value of the underlying position, but only around 20% of the notional value. For example, if a trader sells a put with a $300 strike price, the trade will likely require around $6,000 buying power, even though the notional value of the position is $30,000. If the stock went to zero, the loss would be $30,000 but the likelihood of that is extremely small, so brokers are allowed to let traders use margin.
The actual formulas are a bit complicated and can vary a bit from broker to broker. For most stock options, the amount of capital required is actually the difference in the strike price from a 20% change in the current price. For calls, it is the price 20% above current price, and puts 20% below current price. For way out of the money options that approach being 20% away from current price, there is a minimum margin amount that prevents buying power from ever reaching zero. Because of all the various factors involved, I tend to just use 20% of the strike price as an estimate of buying power required.
Some stocks are so volatile that margin is not allowed. In 2021, there were a number of stocks that were dubbed “meme stocks,” companies that were in bad financial trouble but bought up by a rouge group of traders to force a short squeeze on big institutions. During this period, all option trades had to be cash secured, and naked calls sales were not allowed by many brokers. Stocks in turmoil can also be set to have options cash secured only. This is generally only an issue with smaller stocks that are thinly traded.
Because the risk of selling naked options is undefined, capital requirements for margin is subject to change with any significant change in the price of the underlying stock. Big moves in the price of the stock can trigger the broker to request significantly more capital. For example, if $6,000 was intially required to sell a $300 strike price put, and the stock dropped to $200 a few days later, the position would have a $10,000 loss, plus another $4,000 margin would be required. So, the owner would need another $8,000 of capital to cover the loss and new margin requirements ($6,000-$10,000-$4000). So, margin may vary, although it isn’t that likely to change significantly without a large move in the price of the underlying security.
Futures Span Margin
Futures and futures options are regulated differently than regular stocks and options. One big difference is futures margin is allowed to be used much more for much higher leverage. The CME uses a variety of factors to determine how much capital is required to hold the futures positions in a portfolio. The methodology is called SPAN which is an acronym for Standard Portfolio ANalysis of Risk. The SPAN margin methodology evaluates overall portfolio risk of all futures positions, which can include short or long futures contracts and any futures options. Each position in an account is evaluated for risk based on prices of the security, volatility of the security, interactions between different positions in the portfolio, and minimum short option parameters.
As each trade is opened or closed, the impact on overall portfolio risk is evaluated to determine the level of SPAN margin required. Most brokers do this immediately and a trader can see the impact of a trade on buying power before placing a trade. By holding positions that are likely to move in different or uncorrelated directions, a trader can hold more positions as there is less risk and lower SPAN margin requirements. Since futures include a variety of products, including stock indexes, bonds, currencies, and a variety of commodities, many products can be bought or sold to counter other products in an account and maximize buying power. The formulas get a bit complex, but there are actually online calculators available to allow individuals to determine what capital would be required for a basket of futures positions. The SPAN protocol essentially tries to estimate the worst possible loss that may happen to the futures portfolio within a day based on all known factors.
With individual underlyings like the S&P 500, buying or selling new positions that act as a hedge against existing positions can potentially increase buying power even though a new position is being added. For example, if a trader sells a number of futures option puts on the S&P 500, the buying power required may be 20% of the notional value of the puts. But if the trader then sells S&P 500 futures short outright, the amount of capital required will likely be reduced, because the price movements of the two positions counter each other. Each trade either adds risk or reduces risk to the portfolio, and the SPAN margin is recalculated with each change.
SPAN margin is recalculated throughout the day as prices and volatility changes, so there must be enough capital in an account to handle the increases that may occur due to market swings.
While there is no good rule of thumb for calculating SPAN margin, my experience is that SPAN margin reduces buying power required by a factor of somewhere between 4 and 15 compared to being cash secured, depending on the level of risk being taken. For example, a put spread with a max loss of $800 may require $200 buying power with SPAN margin, while a naked put with a max loss of $15,000 may require $1000 in buying power. Buying or selling an index might require something like 1/8 of the notional value in buying power. These numbers vary widely by underlying product and market condition. They are generally better in reducing buying power required than regular options margin in all instances of risk.
With reduced buying power comes significant leverage and significant increases in risk. A trader with one sided futures positions can experience catastrophic losses with a few days of decent sized moves against the position. A trader must understand the full risk involved with holding positions in futures, and not just rely on the SPAN margin calculation as risk. It is important to realize that SPAN margin is intended to cover one day of risk from market moves, not an extended period of holding.
Using or adding hedges of short or long futures, or changing up options holdings can allow a trader to adjust the directional bias of a portfolio and also make changes to the buying power required by SPAN margin. Generally, trades that move the overall portfolio Delta value closer to zero will reduce buying power required.
SPAN margining is powerful, but complex. To dig into more detail, check out the CME website which has extensive resources on the topic.
Intraday Futures Margin
Futures traders can also increase their buying power with the use of Intraday Futures Margin. Margin can be ratcheted up even more for trades that are open just during the regular trading day. Traders that use this form of margin must close their trades by the end of the day to avoid having the margin requirements return to somewhat higher Futures SPAN margin requirements. As we discussed in the previous segment, SPAN margin allows significant leverage. Intraday Futures Margin provides even higher leverage.
The concept is the same for Intraday Futures Margin. Portfolios are evaluated for risk of moves during the current day to determine how much buying power is required. There is less risk to open a position and close it the same day than to hold it overnight. Seasoned futures day traders make use of this extra leverage.
Portfolio Margin
For traders with large accounts, some brokers provide Portfolio Margin. With Portfolio Margin, the broker evaluates the overall risk of all positions as they interact with each other to determine the margin requirements. The process is similar to SPAN margin for futures, but Portfolio Margin takes into account all options holdings as well as long and short stock positions. Having holdings that are uncorrelated in their movement reduces risk and allows more buying power. The additional buying power can be significant compared to regular options margin.
The potential pitfall of portfolio margin is that in times of crisis, virtually all assets decline together and the value of diversification tends to fall apart. So users of portfolio margin generally try to keep buying power usage lower than a trader with regular options margin.
Watchouts
It can be tempting to think of margin in its various forms as a line of credit, like what a bank might give a homeowner to make home improvements or pay off other bills. A trader has a account balance, and the broker provides the trader with the ability to buy or sell securities beyond the balance, based on the value of the account or security being traded. One big difference is that the broker can change the terms of the margin allowance at any time, generally depending on how the security being margined behaves. When the security that the trader has bought or sold loses value, the broker will likely re-calculate what margin is allowed/required. So margin is not something that can be set up and forgotten- it theoretically changes every day, sometimes a little, sometimes a lot.
Traders using margin need to be aware that margin requirements can fluctuate, and not push the margin to the extreme. Ironically, the biggest risk of margin is generally when the market is calm, volatility is low, and everything seems safe. A sudden change in the market can catch complacent traders unprepared. Option positions are likely to be close to the money to make them have value, so the move can turn an almost sure winner into a big loser quickly. On the other hand, when markets are in turmoil, implied volatility is high and option premium is priced for big problems in the future already. Because higher risk is priced in, the likelihood of a move that wipes out an account is actually less. But whatever the market environment, a trader needs to have a decent portion of capital available to manage whatever issues arise if the market goes against the trader’s positions.
While I’ve tried to give a decent overview of these various types of margin and explain the differences, this is just a high level explanation. There are lots of details to consider that are beyond what I’ve shared, and each broker handles margin a little differently. So, do your homework before diving into this area of risk.
