When shares are purchased, an investor can either pay cash or use a margin account. The initial margin is usually 50 percent of the value of the shares and the maintenance margin is usually 25 percent of the value of the shares. The margin account operates in the same way as it does for an investor entering into a futures contract (see Chapter 2). When call and put options are purchased, the option price must be paid in full. Investors are not allowed to buy options on margin. This is because options already contain substantial leverage. Buying on margin would raise this leverage to an unacceptable level.
When an investor writes options, he or she is required to maintain funds in a margin account. This is because the investor's broker and the exchange want to be satisfied that the investor will not default if the option is exercised. The size of the margin required depends on the circumstances.
Consider first the situation where the option is naked. This means that the option position is not combined with an offsetting position in the underlying stock. If the option is in the money, the initial margin is 30 percent of the value of the stocks underlying the option plus the amount by which the option is in the money. If the option is out of the money, the initial margin is 30 percent of the value of the stocks underlying the option minus the amount by which the option is out of the money. The option price received by the writer can be used to partially fulfil this margin requirement.
An investor writes four naked call option contracts. The option price is $5, the strike price is $40, and the stock price is $42. The first part of the margin requirement is 30% of $42 x 400 or $5,040. The option is $2 in the money. The second part of the margin requirement is therefore $2 x 400 or $800. The price received for the option contracts is $5 x 400 or $2,000. The additional margin required is therefore
Note that if the option had been a put, it would be $2 out of the money and the additional margin requirement would be
A calculation similar to the initial margin calculation is repeated every day. Funds can be withdrawn from the margin account when the calculation indicates that the margin required is less than the current balance in the margin account. When the calculation indicates that a significantly greater margin is required, a margin call will be made.
Writing covered calls involves writing call options when the shares that might have to be delivered are already owned. Covered calls are far less risky than naked calls since the worst that can happen is that the investor is required to sell shares already owned at below their market value. If covered call options are out of the money, no margin is required. The shares owned can be purchased using a margin account as just described, and the price received for the option can be used to partially fulfil this margin requirement. If the options are in the money, no margin is required for the options. However, the extent to which the shares can be margined is reduced by the extent to which the option is in the money.
An investor decides to buy 200 shares of a certain stock on margin and to write 2 call option contracts on the stock. The stock price is $63, the strike price is $60 and the price of the option is $7. The margin account allows the investor to borrow 50% of the price of the stock less the amount by which the option is in the money. In this case, the option is $3 in the money so that the investor is able to borrow
The investor is also able to use the price received for the option, $7 x 200 or $1,400, to finance the purchase of the shares. The shares cost $63 x 200 = $12,600. The minimum cash initially required from the investor for his or her trades is therefore
In Chapter 8 we will discuss more complicated option trading strategies such as spreads, combinations, straddles, strangles, and so on. There are special rules for determining the margin requirements when these trading strategies are used.
Was this article helpful?