Options Trading and Margin Requirements

There are few things that options traders find as confusing as margin requirements. The fact

that there is a difference between the margin requirement for stocks, futures and options
further complicates the issue.

Definition

In options trading the term margin is simply a reference to the cash and/or securities a
trader’s broker requires him or her to deposit as collateral before a particular trade can be
entered into. With cash-settled options, this is the amount in cash that must be lodged against
the potential scenario of the option being assigned.

Margin requirement plays a major role with options selling.

How is margin determined?

For stock options the Chicago Board of Trade has issued a set of guidelines for member
firms, but this does not mean it is uniformly followed by all brokerages. As a matter of fact
traders will find that there are marked margin differences between the margin requirements
of the various brokers, so before depositing funds with a particular broker it is vital to find out
how they calculate margin requirement.

Since the forex market is generally less volatile than the stock markets, particularly the market
for an individual stock, forex options generally have lower margin requirements than stock
options.

In the Forex and Futures Options Markets, many brokers use the Standardized Portfolio
Analysis of Risk (SPAN) system to determine margin. This works beautifully for the trader
since his trading positions are not viewed in isolation. The system rather uses a very complex
algorithm to determine the risk of all the open positions combined – including options and
forex/futures contracts.

The significance of margin for the trader

The one major significance of margin is that this represents money which the trader cannot
use to trade with.

Example:

Let us assume trader John only has $2 000 in his trading account. If one broker should
charge $2 000 in margin for a particular trade and another broker charges only $1 000,
everything else being equal the second broker is the better alternative since trader John will
be able to set up two trades with the same amount of funds in his account. This will allow him
to:

a) Make more money in the same time with his existing capital and
b) Diversify his portfolio to a limited extent with not having to risk all his available funds
on a single trade

Margin requirements for spreads

The trader might at this stage wonder what about margin on so-called spreads, i.e. a
combination of long and short option positions?

Debit spreads such as the well-known butterfly spread will normally not require any margin
from the broker. This is because the trader does not stand to lose an unlimited amount of
money as with naked options selling.

Credit spreads such as the iron butterfly spread, on the other hand, will require a margin
deposit. The amount of margin will inter alia depend on the amount money the trader can lose
on the spread, but it will usually be less than the margin on a naked call or put.