Equity options
The amount of money necessary to initiate and hold a short option position is known as the “margin requirement” or “buying power effect.” To sell options on stocks the margin requirement is quite large because of the necessary cash that must remain in the account for option assignment in a worse-case scenario.
For example to sell a 10-lot of .04 delta puts in SPY, assuming it’s cash secured, $189,000 would be needed to satisfy the margin requirement! And the maximum profit would only be $180. This is not a favorable or effective use of capital.
Although it varies from broker and clearing firm, roughly $18,000 would be needed to initiate this position uncovered (naked), while only $5,022.11 would be needed for an account that has portfolio margin approval. This is a much better use of capital as shown below.
Portfolio margin accounts (PM) offer better margin requirements for equity options and therefore provide more trading opportunities. However the problem is that not every trader has $125,000 to be eligible for portfolio margin.
Futures and forex options
With futures and forex, the margin requirement is generally much lower. This is because of different margin calculations and that the writer of the option is generally not obligated to deliver the entire underlying. Most options are settled in cash anyway.
This means with a relatively small amount of capital, traders can sell options contracts in commodities, interest rates, index products, and forex.
This provides an advantage to option writers.
Brokers will often base the actual margin requirement on what’s called delta + vega margin. With this calculation both the exposure to the underlying and the implied volatility is taken into consideration. To sell one option contract the initial margin would be:
total margin = option delta x spot margin + vega margin
So for example if you sold one option contract with delta of 0.5 you would need half the margin requirement of a spot forex position plus an additional margin for volatility. If the implied volatility in the underlying increases, so will the vega margin component. This will increase your overall margin requirement.
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When an option is deeply in the money, it trades more or less like the underlying. In this case, delta is close to 1, and so the margin requirement for selling the option is more or less the same as for the underlying. Sensitivity to volatility also drops off dramatically as the spot price moves away from the strike price. That means vega drops as well.
SPAN margining
Also, futures and forex options generally use SPAN margining. This system assesses the total risk of a portfolio rather than individual holdings. This results in more reasonable margin requirements for individual positions. All liquid and high-volume futures options use SPAN margining (or a similar formula outside the US).
For example, to sell a .04 delta Light-Sweet Crude Oil put with 24 days to expiration, only $8,633.00 is required to initiate the position. In addition the amount of money received for selling the put can be used towards the margin requirements as well.
The particular short options trade shown in Figure 3 offers roughly a 12% ROI. A trader could also sell 10 calls to neutralize portfolio deltas and receive even more premium.
If the position moves against the trader, the margin requirement can increase. If there is not enough cash in the account to cover the increased margin requirement, a “futures margin call” will be issued.
If this happens, it often seems incredibly scary and ominous. However, it is not the end of the world. Closing out the position (usually for a loss, but not always) or depositing additional funds will resolve the margin call for futures options positions. Note the need to choose a liquid market.
Position sizing
Most margin calls can be avoided through proper position sizing. This is crucial. Big short option positions have the potential to go very bad, very quick.
The position sizing you choose will vary based around your risk tolerance and investment objectives. There are general guidelines that traders follow.
Always leave enough free float: Using 95% of the total cash available in a portfolio for a single option position will almost certainly result in a margin call. This is because from the moment the position is open, the margin requirement will fluctuate as the underlying future moves.
Many brokers offer analyzing tools to see what the theoretical margin requirements would be if the underlying future moved on a percentage basis up or down.
Contract Specifications
One of the main differences between futures options and equity options is contract size, or the amount the option price is multiplied by. For most equity options, the contract size is 100 shares.
So the price of an option for SPY, for example, is simply multiplied by 100 and that is the dollar value of the option.
With futures options, it is important to note that the contract unit varies from product to product. This determines the multiplier of the corresponding options. For example with Light-Sweet Crude Oil, the contract size for options is 1000. This means 1 Light-Sweet Crude Oil futures contract controls 1000 barrels of oil. Therefore, selling a Crude Oil option at 0.14 would produce a net-credit of $140 (minus commissions).
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Exercise style, settlement method (cash or physical delivery), trading hours, contract size, and the minimum price fluctuation all vary between futures contracts, and therefore futures options.
Get to know the specifications of the options you intend to trade before placing live positions.