The market’s volatility over the past year, and certainly since the latter part of 2018, certainly reinforces how critical it is to understand how margin and put selling work together. With that in mind, today I’d like to go over a put sale trading example using margin (keep in mind, please, the numbers I’m about to use are not specific to any particular broker) and talk about the different possible scenarios at expiration and what they mean for a margin account.
Put Selling Capital Requirements
Let’s lay the groundwork first. We’ll assume you want to sell a put option on a stock with a $50 strike price. You’ve set up a brokerage account with $100,000 and been approved for put selling and margin trading. Your broker’s rules for put selling are relatively straightforward.
Cash secured put sale: You must have 100% of the capital required to fulfill a put sale assignment. If you sell ten put options with the strike price I just mentioned, you are required to have enough cash in your account to buy 1,000 shares of the stock if you are assigned. The math is simple:
$50 strike price X 1000 shares = $50,000 cash requirement
For as long as the put sale trade is active (you buy it back from the market or it expires), your broker will limit your funds available for stock or options trades by $50,000. If you are doing cash-secured puts in a $100,000 account, that means that your buying power for other trades is only $50,000.
Margin-approved put sale: You must have 20% of the capital required to fulfill a put sale assignment. If you sell ten put options at the $50 strike price, your broker will only require you to maintain $10,000 in cash for the duration of the trade.
$50 strike price X 1000 shares X .20 margin requirement = $10,000
In a margin-approved $100,000 trading account, requiring only $10,000 in currently available cash means that your buying power for other trades is $90,000 – a significant difference over what you can do if you are selling puts on a cash-secured basis.
End of Trade Scenarios
If the stock closes above the $50 strike price at expiration, the result for your margin account is the same is would be in a cash account. The put option will expire worthless, you keep the premium you took in and the $10,000 hold the trade enforced on your account is removed. If you have no other pending trades in your account, your buying power increases to $100,000 plus the premium you took in.
What if the stock closes below $50? This is actually where things can start to become a little more complicated. If a stock assignment is triggered, your broker’s margin requirements for long stock positions kick in, since now you have to buy the stock at the strike price you sold. We’ll assume that your broker requires 50% of the stock’s purchase price to fulfill the put assignment. You had to keep $10,000 in cash for the duration of the naked put trade, but now, in order to buy the stock you must have $25,000 in free cash (what your broker may call stock buying power) in order to complete the purchase.
$50 strike price X 1000 shares X .50 margin requirement = $25,000
This isn’t the end of the story; exchange rules and federal regulations also require that you keep at least 25% of the market price (which changes every day) of your stock in your account for as long as you own it. Your broker may require a higher maintenance requirement to force you to be more conservative, but they cannot go below 25%. Let’s suppose that your broker’s maintenance requirement is 30% of the stock’s market value. This requirement applies to the equity value of your position in the stock; if that value drops below 30% your broker will issue a margin call (more about that in a bit). If the stock’s price is $45 per share when you are assigned the stock, your maintenance requirement is $13.50 per share, or $13,500.
$45 current stock value X 1000 shares X .30 maintenance requirement = $13,500
The maintenance requirement is recalculated each day as the stock’s price fluctuates. Since the amount the broker loaned you to initiate the stock buy ($25,000) doesn’t change, the net value of the position is the borrowed amount plus your 30% maintenance requirement. If the stock goes up, that’s never a problem, because you’ll be able to sell all 1,000 shares back to the market, pay $25,000 plus margin interest to your broker, and then you keep the difference.
Margin Calls
Things can get sticky if the stock experiences a big drop in price. Let’s suppose, for example that two week after being assigned, the stock has dropped to $30 per share. Your 1,000 shares are now worth $30,000, but your actual equity value is now only $5,000.
$30,000 position value – $25,000 broker equity = $5,000 personal equity
The problem in this case is that your equity value has now dropped below the 30% minimum required by your broker, which triggers a margin call.
$30,000 position value X .30 maintenance requirement = $9,000
To cover the difference, you must have $4,000 in available cash in your trading account. If you don’t have it, you must either deposit sufficient funds to make up the difference or close other positions to make the funds available. In this kind of extreme case, your broker can also force a sale out of existing positions you may have, without advising you ahead of time. This often means that you have no control over which positions may be closed. If you cannot deposit additional funds immediately or close existing positions to make up the difference, your broker can go after your personal property.
Erring on the Side of Caution
As you can imagine, being issued a margin call can create a very stressful situation if you’ve been overly aggressive. In put selling, being overly aggressive means selling as many contracts as your 20% initial margin requirement allows. To make things more manageable, I prefer to think about the potential stock assignment as my guideline for how many contracts I can sell. Since the margin requirement for the initial stock assignment is generally more conservative than the maintenance requirement, this gives me a way to be conservative and make sure that I can have multiple open positions at a time, including long stock positions from stock assignments without taking a big risk of being exposed to a margin call.
Let’s go back to the beginning of our example put sale trade. Let’s suppose that I want to limit my margin exposure on a stock assignment to no more than about 3% of the entire account. If I’m selling a $50 strike price, I know that for every 100 shares I may be forced to buy, and my broker’s long purchase margin requirement is $2,500 (50% of the purchase price), that means that I’m already at 2.5% exposure by selling one contract. I’m not going to sell more than one contract since I’m not willing to expose myself to more than 3%.
It is true that I’m giving you a very conservative example, and that selling only one contract at a time will restrict how quickly my total account will grow. In very practical terms, even if I’m averaging 3 – 5% per month returns on the capital I have committed to any single trade, I may see only 6 – 10% actual growth of my total trading capital over the course of a year. You can expand your risk parameters if you wish; I actually try to limit my total exposure to around 4 – 5% on any given trade. Generally, I don’t recommend going higher than 5%.
I hope you find this helpful! Please keep in mind that the numbers I’ve just given are purposely generalized. I suggest your check your broker’s website or talk to them directly to make sure you know exactly what their margin requirements are – not just for the put sale, but also for long stock purchases and maintenance requirements. If you are trading on margin, don’t do it with only a part of the overall picture, or you could leave yourself unintentionally open to a margin call you didn’t expect.