Understanding Margin Requirements for Selling Naked Puts

   
Understanding Margin Requirements for Selling Naked Puts

If you plan to sell put options, you need to understand the margin requirements. So we’re going to lay out the trading authorizations your broker will require in order for you to execute this type of trade and explain the margin requirements.

We frequently employ a strategy whereby we sell a put option to pay for a call option. We identify these trades as credit or debit spreads. This strategy works well when stocks are appreciating, say options trading articles. When call premium is high, selling puts to reduce the cost of the trade greatly improves the likelihood of earning a profit and enhances your return.

We know it can be frustrating to buy a call on a stock that goes up and the call loses money. Much of the time, the implied volatility priced into the options was greater than the realized volatility of the stock. As a result, the stock can rise and the option expires with little or no value.

The downside of selling a put to buy a call is that you are exposed to potentially escalating losses if the stock declines below the put strike price. At expiration, if the stock depreciates below the put strike price, you are very likely to be put the stock and assume the loss represented by the amount the stock price is below the put strike less the net premium collected.

Understanding Naked Put Selling Margin Requirements

For our examples we’ll use Charles Schwab margin requirements because they are higher than the minimums required by the Financial Industry Regulatory Authority (FINRA) and the option exchanges for option trades on basic stock. Schwab’s margin requirements are representative of the industry. You should check the specific requirements of your broker to know exactly what margin standards they apply.

Please note: Having margin clearance within your brokerage account does not mean you will be forced to go on margin with your options trades. If you have enough cash or stock holdings within your account to cover the margin requirements, then a trade will not trigger the activation of the margin (borrowing capacity) that is available to you.

Options Trading Approval From Your Broker

When you open your account with a broker, you should request options trading authorization. At Schwab, they classify options trading clearance with four categories of approvals ranging from 0 to 3. (For more on this, see Option Approval Levels Explained.)

To buy calls, you will need to obtain at least Level 1 approval. As explained below, you can also sell naked puts with Level 1 clearance, but the margin requirements are much higher than if you have Level 3 trading authorization. If you have the necessary experience, we highly recommend you obtain Level 3 approval.

Our “spread” trade is a two-legged trade; we buy a call and sell a put. In the industry, this is often referred to as a risk-reversal trade.

The first leg of our trade involves buying a call. When you buy a call, your total risk is the amount of dollars you paid when you initiated the trade. Even if the stock goes to zero, you will have no additional liability. You will also have lost all of your initial investment. Again, if you trade with Schwab, you will be required to have Level 1 trading approval.

The other leg of our trade involves selling a put naked. Before you can consider selling a put naked, you must have:

* An account balance of at least $25,000 net equity value.

* Schwab’s Level 1 options trading authority to sell a put naked on a cash-secured basis

* Schwab’s Level 3 options trading authority to sell a put naked on margin.

Schwab does allow investors to sell puts naked on a cash-secured basis in an IRA account as long as they have Level 1 options trading authority and the account has more than $25,000 of net equity value.

What is Cash Secured?

Selling a put to open on a cash-secured basis requires that you carry the full potential cash obligation of the trade in your account.

For example, if you sell to open 10 contracts of the Palm (PALM) May 5 Puts on a cash-secured basis, Schwab requires that you have $5,000 in your account (10 contracts x 100 shares per contract x $5 stock price = $5,000 — see the sample transactions below). If you are put the stock at $5, having the cash in your account insures that you will be able to honor your purchase obligation.

Naked Put Selling on Equities — Level 3 Margin Requirements (Schwab)

Stocks $5 and Greater

The good news is the margin requirement if you have Level 3 clearance is substantially less than the cash-secured requirement. The bad news is calculating Schwab’s Level 3 margin requires doing a bit more math.

The margin required with Level 3 approval usually is the solution for the following equation:

(25% of the underlying stock’s market value + the option ask price – any out-of-the money amount) x 100 (per contract) x the number of contracts

The value of the above equation must be greater than:

* (The option ask price + 10% of the stock’s current trading price) x 100 (per contract) x the number of contracts, or

* The number of contracts x $500 per contract.

If either of these two calculations yield a higher margin amount, then the highest value is used.

Stocks Less Than $5

For stocks that are trading below $5, selling naked puts is done on a cash-secured basis in all accounts.

Example Margin Calculations

The following four examples cover stocks than range in price from $2 to $65. Schwab’s margin requirement is shown in the black box in the column entitled “Margin Required”

http://www.bigmoneyoptions.investorplace.com/images/charts/4-27-10-margin.jpg

Exceptions

The margin requirements shown above are for equities and narrow based indexes. Broad-based indexes have lower margin requirements. Double- and triple-levered ETFs have much higher margin requirements.

In any event, always check with your broker on current margin requirements. FINRA, option exchanges and brokers change their margin requirements periodically.

If you are an experienced trader comfortable with going on margin, this can be a good tool in your trading arsenal.

But we want to emphasize again, having margin clearance within your brokerage account does not mean you will be forced to go on margin with your options trades. If you have enough cash or stock holdings within your account to cover the margin requirements, then a trade will not trigger the activation of the margin (borrowing capacity) that is available to you.


Article printed from InvestorPlace Media, http://investorplace.com/2010/04/margin-requirements-for-selling-naked-puts/.

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