What Is Margin Trading? Understanding the Basics

In this article my aim is to demystifying what is margin trading. We will cover how margin works for option sellers. Understand in-the-money vs. out-of-the-money, and show practical examples and tips for managing margin effectively.

what is options margin

Understanding Margin In Options Trading

The premium of a traded options is subject to a “cash” settlement. Meaning, it must be paid by 9:45am on the business day following the day of the transaction.

The holder of a traded option has the right, but not an obligation, and therefore his loss is limited to the premium and so he does not have to lodge any margin.

The writer of a traded option, on the other hand, does have an obligation. He must either deliver the underlying security if he has written a call or buy the stock if he has written a put.

Since the terms of all traded options contracts must be honoured on exercise., provision must be made to ensure that writers of contracts are able, at all times, to fulfil their obligations.

For this reason, writers are required to provide collateral.

This collateral is known as margin and it is calculated by reference to both the share price of the underlying security and the exercise price of the option.

How Is Margin Calculated?

The value of the margin required is calculated as follows:

Take 20% of the share price of the underlying security and either add the amount by which the option is in-the-money or deduct the amount by which it is out-of-the-money.

AUTHOR'S NOTE: ITM and OTM

An option is said to be ‘in the money’ (ITM) or ‘out of the money’ (OTM) and that determines its intrinsic value.

A call is said to be OTM if its strike price is higher than the current market price and ITM if its strike price is less than the current market price.

If a call is OTM it has no intrinsic value whereas an ITM call has intrinsic value equal to the market price minus the strike price.

A put is OTM if its strike price is less than the current market price and ITM if its strike price is above the current market price.

If a put is OTM it has no intrinsic value whereas an ITM put has intrinsic value equal to the strike price minus the market price.
Out of the Money (OTM):

The Covered Call Writer / Seller

A covered writer of a call option (covered call) is one who owns the underlying security.

He is known as “covered” because, if the option is exercised, he will have to sell the security at the exercise price. He is able to do so from his existing holdings, rather than having to go into the market to buy it first.

If he deposits the actual share underlying the option contract as collateral – rather than other forms of margin described below – this is known as “cover”.

He will continue to earn dividends etc from the share, until such a time as he is assigned.

The Naked (Uncovered) Call Writer And Margin

A naked writer does not own the underlying security. As a safeguard against him defaulting, he must deposit margin. It may be lodged in any of the following forms:

  • Cash – This may be provided in either sterling or dollars.
  • Ordinary shares – Any security underlying a traded options series, plus any SEAQ Alpha designated stock.
  • Security convertible into any of those underlying stocks. American Depositary Receipts in respect of an underlying security which is in a traded option class.
  • British funds, fully or partly paid. E.g. gilts.
  • Treasury bills
  • Local Authority Bonds
  • Corporation and County Stocks
  • Certifications of Deposit
  • United States Government Treasury Bonds, Treasury Notes and Treasury Bills.
  • Such other securities as are approved by the Council of The Stock Exchange.

N.B. Interest is not paid on cash deposited as margin. Therefore, it is usually more efficient to lodge collateral in one of the other forms listed above, rather than in actual cash.

How Is Margin Calculated?

The value of the margin required is calculated as follows:

Take 20% of the share price of the underlying security (stock, ETF etc.,) and either add the amount by which the option is in-the-money. Or deduct the amount by which it is out-of-the-money.

Example: 

ABC Nutrition stands at $190 per share. 

If trading on margin, the margin required from the covered call writer that is selling ten contracts of the $180 call is calculated as follows: 

20% x $190 = $38
Add amount by which option is in-the-money = $10 
Margin requirement = $48
Margin for the ten contracts = $48 x 100 x 10 = $48,000

A covered call seller of the $200 series would only have to deposit $28 per option or $28,000 for ten contracts ($38 - $10 x 100 x 10).

This is because the exercise price is higher than the share price, i.e. out-of-the-money. 

For put options, the calculation is the same, except the adjustment is reversed. 

In our example above, the writer of the $200 cash secured put option would need to deposit $48 per option ($38 plus $10). 

Whilst the writer of the $180 put option - which is out-of-the-money, would need to lodge only $28 ($38 minus $10). 

The figures quoted above are the minimum permitted margins. But since the amount of margin required is adjusted daily. This is in accordance with the movement of the stock. Brokers normally require you to have larger cash balances available if you wish to trade options against margin.

AUTHOR'S NOTE: 
Other types of options are less volatile than equity options, so the margin requirement is lower. 

The margin percentages are as follows: 

Index Options /// 12.5% 
Currency Options /// 8% 
Stock /// 20% 

Spreads And Straddles – Margin Concessions

Reductions in margin requirements are allowed at the following times: In certain circumstances, where the writer of contracts in one series is also the holder of contracts in another series of the same class.

Where the writer of a call option is also the writer of a put option in the same class.

We are, of course, referring to the writing of spreads and straddles. The exact circumstances in which these margin concessions exist are explained below:

AUTHOR'S NOTE:

An option class consists of options of the same type (calls or puts) listed on a specific underlying security. 

Within an option class, there are subsets known as option series, comprising all calls or puts for that underlying asset expiring in the same month. 

Spread Positions

Where the investor is both a holder and writer of call options in different series of the same class, and the expiry date of the series held is the same as or later than the series written, the margin requirement is calculated by reference to the two exercise prices as shown below:

If the exercise price of the series held is higher than the series written, margin is calculated by multiplying the difference between the two exercise prices by the number of shares involved on the written side. This is the maximum amount payable.

If the normal margin requirements is less than the figure, then the lower amount is payable. If the exercise price of the series held is the same as or less than the series written, no margin is required.

The same concessions apply to puts, except margin is now not required when the exercise price of the series held is higher than or equal to the series written.

Straddles

The writer of a straddle sells a put and a call on the same underlying security, both having the same exercise price and expiry date.

Where an investor has sold a straddle, margin is levied on both written positions in accordance with the normal margining formula; the lower figure is then disregarded and the higher amount only is payable as margin.

Payment Of Margin

All margin required from the writer of a traded option contract following an “opening sale” must be made available to his broker by 9:45am on the business day following the day of transaction.

A word of caution before wrapping up this article on margin trading.

If the market were to experience a category 5 hurricane, like that seen during COVID-19, your margin requirement will increase substantially.

This can cause people the utmost stress. Cash, as they say, is always king. Do not build your kingdom on margin.



Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

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Kevin S

Kevin S

Greetings, I'm Kevin! I am now a full time options trader and investor. I am thrilled to have the opportunity to share my knowledge and expertise with you. My objective is to assist you in navigating the complexities of option trading, regardless of whether you're a beginner or an experienced trader looking to enhance your skills. I'm excited to accompany you on your journey to mastering the art of option trading. Let's make this year an extraordinary one for you!

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Welcome to Dividend On Fire, we are a site dedicated to options trading! We specialize in helping investors generate passive weekly or monthly income through selling cash secured puts and covered calls.

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