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
, 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
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.
Because an at-the-money covered call, or buy-write position, has essentially the same risk/reward in dollar terms as shorting its related put, a look at its initial margin requirement dovetails nicely with lasts week's discussion of using return on investment as a tool for comparing positions with similar profiles.
The minimum initial requirement for a covered call is: 1) 50% of the stock price less the proceeds from the call sold, or 2) 30% of the strike price. So a buy-write position in Yahoo!, in which you buy shares and sell the January $30 call on a one-to-one basis, would require ($30 x 0.50)- $3.50 = $11.50, or $1,150 per 100 shares covered. (Again, because the latter formula results in just a $900 requirement, we apply the first formula.)
The maximum return on investment for this bullish position is 30%. You could also sell the January $30 put for $3.60, which would have an initial margin requirement of $960 a contract and a potential return on investment of 37%. Clearly in this example selling puts offers a better return on investment.
One thing to be aware of is that in stocks with options that sport very high implied volatilities, you'll find that the covered call can offer a better return on investment than selling the corresponding put. This is because the premiums collected from the call get subtracted from the initial margin requirements of a covered call, whereas the premium collected from selling short puts is added to the total margin calculation.
For example, with
trading at $20.90, you could sell the January 2006 $20 put for $4.50, which has a margin requirement of $778 per contract and a potential yield of 57% for the 18-month period. Or you could sell the January 2006 $20 call for $6 against a long stock position, creating a covered call with a margin requirement of just $445, which would have a maximum return on investment of 114% over the same time period.
Aside from the fact that Sandisk options have an implied volatility of 70 as opposed to Yahoo! options' implied volatility of 40, the time remaining is also an important factor for reducing the covered calls' margin requirement and boosting the return on investment. Unfortunately, with volatilities sitting near eight-year lows, there are relatively few attractive covered call candidates for taking full advantage of the reduced margin requirements.
Of course, every brokerage firm has the right to set its own requirements, which will vary based on the specific issue, position and, most importantly, how highly your account is valued in terms of dollar amount and trading activity. Typical brokerage margin requirements for many popular options positions, including spreads, butterflies and other multistrike strike strategies, along with options with stock positions such as collars, can be
viewed at this site.