Lessons from the Pros

Options

Buying Power Required for Options Trades

Options can be used in any one of three distinct modes:

  • As a leveraged speculation on the price of a stock or ETF – making more with less
  • As protection for a stock/ETF position
  • As a cash-flow generating device (aggressive or conservative)

Each one of these modes works well when used to its best advantage.

When trading options in any of these ways, it is necessary to know just how much cash will be required for each position. This is not quite as simple as it is when buying or selling short the shares of the stock or ETF itself. But it is not difficult when you know a few simple principles.

Cartoon man opening his shirt to reveal Moneyman suit.

Here are the major rules for determining the amount of cash required for option positions. Please note that these are general guidelines – you should check with your broker for any differences in the specifics.

  1. If the maximum theoretical loss on an option position is limited, that maximum theoretical loss is your buying power requirement.
  2. If the maximum theoretical loss is unlimited, you put up an initial deposit (very roughly speaking) of about 20%. You may be required to add more.
  3. If you are selling an option that is secured by an existing position, no additional buying power is needed.

Examples of Cash Requirements for Different Option Strategies

For each strategy, the buying power requirement is shown in [square brackets].

Option Strategies Where the Maximum Theoretical Loss is Limited

Leveraged Speculation Strategies:

  • Buying call options as a bullish speculation [premium paid]
  • Buying put options as a bearish speculation [premium paid]
  • Debit spreads including vertical, horizontal, diagonal and butterfly [net premium paid]
  • Long straddles or strangles (must pay for both calls and puts) [premium paid]

Protection Strategies:

  • Buying protective put options to insure an existing or new long stock/ETF position [premium paid]
  • Buying protective call options to insure an existing or new short stock/ETF position (uncommon) [premium paid]

Cash flow generation Strategies:

  • Credit spreads [difference between strike prices, less net premium received]
  • Double-sided Credit spreads (iron condors or iron butterflies) [difference between strike prices, less net premium received, for the larger of the two spreads]
  • Double-sided Debit spreads (double diagonals, double calendars, long butterflies, long condors) [net premium paid]
  • Short puts secured by cash [strike price of the put]

Option Strategies Where the Maximum Theoretical Loss is Unlimited

Since the maximum loss can’t be calculated, your broker requires you to put up a deposit when entering the trade. If the trade goes against you by a certain amount, your broker will then require you to put up more cash to maintain the cushion. This applies to:

Leveraged Speculation or Cash Flow Generation – the following can fall into either category, depending on strikes selected:

  • Selling call options naked (without owning the stock and not as part of a spread). [Roughly 20% of the stock value, plus or minus]
  • Selling put options naked [Roughly 20% of the put strike, plus or minus]
  • Ratio spreads, where more options are sold than bought [margin for the credit spread, plus margin for the extra naked short option]
  • Double-sided naked strategies (short straddles, short strangles) [roughly 20% of call strike, plus or minus]

Adding Short Option Positions Secured by an Existing Position

In this type of trade, you are selling an option, and you previously owned the means of satisfying the obligation. In these cases, you get immediate credit for the new option sold, with no requirement for any additional buying power:

  • Selling a call against stock already owned, creating a covered call [no margin required]
  • Selling a put against a short stock or ETF position [no additional margin required]
  • Selling a call against an existing long call, creating a debit spread (vertical, horizontal or diagonal) [no additional margin required]
  • Selling a put against an existing long put, creating a debit spread (vertical, horizontal or diagonal) [no additional margin required]

Free Trading WorkshopAs you can see, there are a number of permutations, but each is just a particular case under one of the three modes. Once you have that mastered, it’s easy to determine just how much cash your proposed option strategy will tie up. That money tied up is your investment in the position. Knowing that, you can easily calculate your return on investment.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Join over 170,000 Lessons from the Pros readers. Get new articles delivered to your inbox weekly.