What is Option Margin
Option margin is the cash or securities an investor must deposit in his account as collateral before writing - or selling - options. Margin requirements are established by the Federal Reserve Board in Regulation T and varies based on the type of option.
BREAKING DOWN Option Margin
Option margin requirements are very complex and differ quite a bit from stocks or futures margin requirements. In the case of stocks and futures, margin is used as leverage to increase buying power, whereas option margin is used as collateral to secure a position.
Minimum margin requirements for various types of underlying securities are established by FINRA and the options exchanges. Brokers may have very different margin requirements since they can add to the minimum requirements set by regulators. Some option strategies, such as covered calls and covered puts, have no margin requirement since the underlying stock is used as collateral.
Traders must request options trading authorization when opening a new account. Often times, brokers will classify options trading clearance levels depending on the type of strategies employed. Buying options is typically a Level I clearance since it doesn't require margin, but selling naked puts may require Level II clearances and a margin account. Level III and IV accounts often have lower margin requirements.
Option margin requirements can have a significant impact on the profitability of a trade since it ties up capital. Complex strategies, such as strangles and straddles, may involve computing multiple margin requirements. Traders should determine the margin requirements for a trade before entering into it and make sure that they can meet those requirements if the market turns against them.
How to Avoid Option Margin Requirements
There are several different strategies that can be used to avoid option margin requirements.
- Covered Calls and Covered Puts - Covered calls and covered puts involve owning the underlying stock, which is used as collateral in the option position. For example, if you own 500 shares of QQQ, you can sell to open five contracts of QQQ call options without any margin.
- Debit Spreads - Debit spreads involve buying in-the-money options and selling out-of-the-money options. In this case, the right to exercise the long option at a more favorable strike price offsets the obligation to sell at the less favorable strike price, which means that no margin is required.
Calculating Option Margin Requirements
The easiest way to calculate option margin requirements is using the Chicago Board of Options Exchange (CBOE) Margin Calculator that provides exact margin requirements for specific trades. Traders can also see the minimum requirements in the CBOE's Margin Manual. Brokerage accounts may have similar tools available to provide an idea of the cost before entering into a trade.