Margin Requirements

[Igor 10]

A margin requirement is the minimum balance a broker house requires an investor to have in their account when writing call or put options. The requirements vary depending on the broker and the terms agreed upon when opening the account.

 

Every bank account has a balance and the balance increases when the owner makes deposits and decreases with withdrawals taken from the account. Investment accounts act in the same way except traders call their account balance "margin," because their broker uses it as collateral to cover their trades.

 

Option traders can sometimes borrow money from the brokerage house to increase their margins or cover orders when they are short on cash. Borrowed margins have even stricter requirements, cost more when adding interest charges and can be called sooner by the broker, if the investment loses significant value.

 

How to Calculate Margin

Every brokerage house has different margin requirements. In general, brokers only let traders write options on a 10%-20% margin (balance in the investment account). If the investment does well their margin increases. If the trade goes bad, the brokerage house sells the option (margin call). A margin call occurs the instant an option drops below the trader's margin requirement, covering the trade and minimizing loss. Margin requirements fluctuate as the market price moves up and down from the strike price and the requirement increases when short selling.

 

Initial margin requirements are:

• 100% of option proceeds, plus 20% of underlying security value less out-of-the-money amount, if any
  
• minimum requirement is option proceeds plus 10% of the underlying security value
  
• proceeds received from sale of call(s) may be applied to the initial margin requirement
  
• after position is established,*ongoing maintenance margin requirement applies,*and an increase*(or*decrease) in the margin required is possible
  

 

For simplicity, assume that GE's market price is at $20 in all the examples below.

 

Selling a Call (Shorting)

 

Example

1) Investor wants to sell (write) 10 GE-January call options, expiring on 02/15 with a strike price of $20 for $1

 

Result: The option trader would need 20% of the total market value of the securities in case the buyer chooses to exercise the option. This amount works out to $5,000 but since he was paid $1,000 for this option the trader only needs $4,000 in his account to place this call order.

 

Selling a Put (Shorting)

 

Example

1) Investor wants to sell (write) 10 GE-January put options, expiring on 02/15 with a strike price of $20. (Symbol: GE JAN20).

 

Result: Again, the option trader would need 20% of the total market value of the securities in case the buyer chooses to exercise the option. This amount works out to $5,000 but since he was paid $1,000 for this option the trader only needs $4,000 in his account to place this call order.

 

Borrowing on Margin

Sometimes an investor needs more money to make a trade. When the trader has a good credit standing, they can ask their broker to lend them the funds needed to place an order. The broker house charges interest on top of the loan. Profits from borrowing on margins decrease significantly because the trader splits gains with the broker house. The borrower's risk also increases because the broker house will always get paid back, if the investment goes bad.

 

Example

1) Call option available: 10 GE-January call options, expiring on 02/15 with a strike price of $20, and premium of $2. (Symbol: GE JAN20)

2) Investor wants to buy 10 call options at $2 = $2,000.

3) Investor only has $1,000 on margin and asks his broker to lend them $1,000 at 5% interest.

 

Result: The margin requirement is $1,000. If the option's market value decreases $1,000, the broker will call the option and sell it immediately to cover the loan. The investor's account will hit $0, and they will need to deposit more funds to make future trades and to pay interest due to the broker.

 

Margin Calculator

 

Provided by CBOE is this useful online tool that calculates the exact margin requirements for a particular trade.

 

NEXT: See our Options Forum