How to Calculate Margin for a Credit Spread

Focus: 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.