Options Forum: Return On Investment Redux

Steve:

Thanks for last week's explanation on margin requirements for shorting puts. Is it the same for naked calls? Is there some rule of thumb for all option positions? Thanks,

-- J.

Last week's discussion on margin requirements for shorting puts apparently caused many readers to wonder if they really understood how initial requirements for trading options are determined and whether their brokerage firm is particularly onerous.

There are, in fact, definitive guidelines; they are known as the exchange minimum requirements, to which options exchanges have agreed to adhere. Regulation T requirements are set by the Board of Governors of the Federal Reserve, while various governing bodies such as the Securities and Exchange Commission and the Options Clearing Corp. provide oversight and enforcement to prevent any exchange from undercutting these minimum requirements in an attempt to win market share. Here's a link to a full and detailed discussion on exchange minimum requirements.

However, before everyone wades through that 41-page document, allow me to answer the reader's question, and more importantly, offer an example of how comparing margin requirements can help determine which position offers the superior return on investment.

The minimum exchange requirement for a naked or short call option (a bearish position in which the maximum gain is the amount of the sale price or premium collected of the call option and is realized if the underlying share price is below the strike price at the expiration date, rendering it worthless, but with a potential loss that is unlimited) is the proceeds or premium received from the call sold, plus the greater of: 1) 20% of the underlying security purchase price less the amount the call is out of the money, or 2) 10% of the purchase price.

Here's an example: With Yahoo!(YHOO) trading at $30 on Friday, you could sell the $30 call, which expires in January 2005, for $3.50 a contract. The margin requirement for this would be (0.20 x $30 + $3.50) - 0 = $950. (In this case, because 10% of the purchase price is just $300, the first formula is applied.) So, as we discussed last week, the maximum return on investment for this bearish position, when based on the initial margin requirement, would be 36% (350/950) during the six-month holding period.