Options

Credit spreads are growing in popularity as traders become more comfortable with how to use options. However, one thing that often trips up new traders is the margin requirement that comes with some of these more complex trading strategies. Let's take a closer look at what a margin requirement is and how it is calculated.

Credit Spread

But first, we need to define a credit spread. A credit spread typically involves the simultaneous purchase and sale of out-of-the-money puts (a bullish spread) or calls (a bearish spread) that expire at the same time but have different strike prices. The written option is closer to the money than the purchased option and therefore has a higher premium, giving the investor a net credit in his account.

For example, let's consider the hypothetical shares of XYZ, which are trading at $50. If the trader is bearish, he might sell the June 55 call and buy the June 60 call. On the other hand, if the trader is bullish, he might sell the June 50 put and buy the June 45 put.

The goal of using credit spreads is for both options to expire worthless so that the investor retains the net premium collected. The worst-case situation is for both options to finish in the money, in which case the case the maximum loss is the difference between strike prices minus the premium collected.

Understanding Margin

Margin is collateral that the holder of a financial instrument must deposit to cover some or all of the credit risk of his counterparty (most often his broker or an exchange). This risk can arise if the holder has done any of the following:

  1. Borrowed cash from the counterparty to buy financial instruments
  2. Sold financial instruments short, or…
  3. Entered into a derivative contract

The collateral can be in the form of cash or securities, and is deposited in a margin account.

Margin is required in your account to cover for the worst-case scenario. For example, let's say that the difference between the two strikes that were used in the credit spread was five points, and the trader received a credit of $1. In this case, the maximum risk would be $400 per contract ([5-1] x 100). As a result, the trader would need to keep at least $400 in his margin account to cover the credit spread. Should both options finish out of the money, the return on margin would be 25% ($100 premium collected/$400 margin requirement). All figures are before commissions.

As for the amount of capital needed to be effective, it all depends on the level of risk you're willing to assume. Front-month credit spreads that are roughly 3% out of the money can result in a high winning percentage (and a lower return per trade). Because of the conservative nature of these trades, you could probably allocate up to a third of your options trading account per trade. Increasing your credit by getting closer to the money is a riskier play, but with a bigger payoff. For this increased level of risk, you would probably want to back down the allocation to a range of 10% to 15% per trade.

By the Staff at Schaeffer’s Research

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly, and monthly newsletters.

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