Understand your risks as an option trader!
Trading Uncovered vs. Covered Options
In options trading, an uncovered option refers to a call or put option that is sold without having a position in the underlying stock. An uncovered option can also be referred to as a naked option.
The reward potential is limited to the contract’s premium when selling options, while the risk can be much more significant. Writing naked calls and puts is a risky strategy that should only be used by experienced traders who understand how to manage their notional exposure and risk.
For the seller, equity options come with assignment risk. This means you are obligated to take a position in the underlying stock anytime the option buyer decides to exercise.
The notional value of an option refers to the total value of a position and how much value a contract is commanding.
For example, if you sell a $10 strike put on a stock, this trade has a notional value of $1,000. The multiplier for equity options is 100, so for a $10 stock, we get $1,000 in total value per contract. When selling cash-secured puts, you cover all the contract’s notional value with cash. You would have to set aside $1,000 to sell this $10 strike put.
When selling naked puts, your broker will only require you to have around 20% of the notional value set aside. Therefore, to sell a $1,000 strike put, you would only have to set aside $200. This does not make the trade any less risky, but you use buying power more efficiently.
Stock Margin vs. Options Margin
● Stock Margin
With a Regulation-T margin account, you are offered margin privileges so that you can leverage your account without taking out a loan from the bank.
The way stock margin works is that you must only set aside 50% of the position’s notional value. Once you are using more notional value than cash in your account, you are charged margin interest on this amount.
For example, let’s say that you have a $10,000 account. If you were to buy $10,000 worth of stock, you are not charged margin interest, and the buying power required would be $5,000.
Now let’s say that you decide to max out your margin usage and purchase an additional $10,000 worth of stock. This would put you at a total notional value of $20,000. You are now being charged margin interest on $10,000 and have no available buying power. Your buying power usage would be $10,000, or 50% of the notional value.
● Options Margin
As an option trader, the broker will only require you to set aside collateral to sell options contracts. Buying options are treated the same as stock, and some brokerages won’t even allow you to use margin to purchase options.
Selling options is where it gets interesting because you are only required to put up around 20% of the notional value as collateral. You can essentially gain up to 5x leverage while avoiding margin interest.
Let’s look at an example of a $10,000 account again to break this down. Instead of buying $10,000 worth of stock, you decide to sell put options that carry a notional value of $10,000. To keep it simple, we can say that you sold a $100 strike put option with a notional value of $10,000.
However, the broker will only require you to put up 20% of this as collateral which is $2,000. This means you can sell five contracts before maxing out your buying power of $10,000. Doing so will command a notional value of $50,000, and you will not pay a dime in margin interest.