Option Margin Requirements for a Buy-Write

Options Trading Topic: Margin Requirements for a Buy-Write

Folks, Here is an exchange of letters with a reader which you may find interesting if you've done buy-writes. It illustrates the not-as-simple-as-it-seems nature of the buy-write margin calculation.

Dear Options Trading FAQ:

Here's another discount broker horror story you can add to your horror story "portfolio". I tried doing a buy-write today. I knew it was going to be difficult going in, but I didn't expect them to flub it THIS badly!

I was trying to buy 100 shares of MU at 50 1/2, and sell the Jan 1998 50 call at 18. The margin requirement for this is an incredibly low $725 (yes, I realize there could be a margin call if it goes down), due to very inflated premiums and the use of a 2-year LEAP. The buy-write gives me downside protection of 25%, to about 38, and the return on margin is 149% if called, and 163% if unchanged. I realize now that I would rather have sold the 55 calls which give me 5 more points to the upside for only 1 point less protection on the downside. Maybe this worked out for the good, since I will have to attempt the trade again tomorrow - read on...

Well, first the LEAP threw them. Even though I was very clear in saying "January, 1998 50 calls" AND gave them the symbol, they insisted on quoting me the January 1996 calls. I also had to explain several times what I was doing. They thought I wanted to buy both the stock and the options. I got switched over to another broker, who seemed to understand buy-writes. He gave me a new quote, and it looked like we were ready to roll. Until... "you will be bringing in a check for $3600, right?".

After several more minutes, I still hadn't gotten through to him. I had at least convinced him that the margin requirement couldn't POSSIBLY be higher than $2525, if I were simply buying the stock, and forget about selling the option! I wrangled him down to $1800, but that was it. I got his name, muttered "I'm going to hold you to this trade", and hung up.

Next, I placed a call to their margin clerk. I left him a voice mail, and didn't expect to hear from him till the next morning. Well, actually, I heard from him about 5 minutes later, as apparently he'd been brought the trade from order-taker #2. I was very polite and said that perhaps I'm wrong, let's just go through this step by step... We both quickly agreed that the broker had incorrectly used the effective price of the stock instead of the market value in calculating the margin requirement. Yes, it did cost me $33 a share, but it's WORTH $50! Doh!
By this time it was 1:02 (4:02 eastern). (I first called at 12:45). He asked me if I wanted him to "drop the ticket". I was skeptical of the time (glancing at my atomic clock - well, it's synched to my Internet provider, anyway...) but I said "yes". He seemed to think there was time. Of course, there actually was enough time, since I'd placed a market order, giving up any hope that they could successfully do a contingent order. They could have still sold the option - there were 8 minutes left - and they could have easily picked up the stock in the after-hours market.

When I called back to check on my order, there was again much confusion. I finally got a call back from the head trader who explained that it had been too late (OptionFool, you DO have a big clock where everyone can see it, right?) but that he could put it in "first thing in the morning". He also reiterated my suspicion that the order could have gone through anyway - "this could have just been a market order". Yep, it sure could have, since that's the way I placed it! Anyway, I decided to look at the numbers again in the morning and start all over. (Hopefully, head honcho will have a little talk with the troops in the meantime...)
How about that?

Know More Than They Do

Dear You Know More Than I Do Too!

Now I feel really stupid. Glancing at the figures in your "horror story", I don't see where some of the numbers mentioned come from. What is the 725, 3,600 and the 1,800? How do you figure the 725? Why wouldn't it be calculated like this?:
Buy the stock at 50 1/2 Sell option at 18 _________ net debit = 32 1/2 x 100sh = 3,250
At 50% initial margin, the cash req is 1,625

The concept is this: Buy the stock and offset the purchase requirement by bringing in usable cash from a covered option sale.

The Options Trading FAQ

Dear Option FAQ:

I’m disappointed in you! You're figuring it the same way my broker did. Guess brokers just think that way. :)

The margin guy at Jack White agreed with me. Now, if it turns out that I'm wrong (I will allow for the possibility, but remember, now you're fighting both me AND Larry McMillan...) then JW is *really* hosed-up, and I'd sure like to know so I can toss McMillan and find another bible.

I explain below where the $725 figure comes from. $1800 is, of course, how much the sale of the option brings in. I still can't figure where the $3600 came from. It's just a number the broker pulled out of thin air.

The net debit isn't the right calculation. Here's why. Let's do a question and answer:

Q. How much is the stock worth?
A. It's worth $5050.

Q. How much can you borrow against it?
A. $2525 - wait a minute - I see where this is going - you're trying to trick me!

Q. No, I'm not. :) How much cash do you have to put up to buy the stock?
A. $2525.

Q. Right. Now, I'm selling an option for $1800. What I get when I sell the option sure looks like cash! So, after crediting the $1800 - cash - I receive for the option, how much more margin do I owe?

A. $2525 - $1800 = $725 Damn! Don't ever let em' count their own change!
Q. You're still skeptical, I can tell. OK, tell you what: I'll just put up the full $2550 margin for the stock.

A. Now you're talking!
Q. Now, about that option premium... It brought in $1800. I've been eyeing that big-screen TV down at the Appliance Mart. Mind mailing me a check?

A. Wait a minute - you're going to send me $2550, and I'm going to send you $1800... Oh.... Doh!

At first glance, net debit appears to be the right basis for the margin calculation. But it's wrong. The reason it's wrong is that it values the stock (for loan purposes) at the effective cost, rather than the market value. Looking at it yet another way, using the net debit disallows part of the current market value of the stock - in fact, 2 times the option premium - from the loan value of the stock. What? Because I only paid $39 for it, it's only worth that? :) In the case of LEAPS, and in particular 2-year LEAPS on a highly volatile stock - 2X the option premium is a very significant percentage (more than half) of the price of the stock.

I believe that the sequence of calculations in McMillan is the correct one.
Actually, the requirement is 766.50. Here's the calculation. I made an excel spreadsheet with the calculations from McMillan (2'nd edition - pp 43-45). I've attached the output from the spreadsheet.

Margin interest rate 9.00 % Margin rate (regulation T) 50.00 %
STOCK PURCHASE stock price 50.75 shares purchased 100.00 commission 36.00 Annual dividend/share 0.20 Annual dividend 20.00
OPTION SALE option price 18.25 contracts sold 1.00 commission 36.00 strike price 50.00 Months to expiration 25.75
NET INVESTMENT REQUIRED stock cost 5,075.00 plus commissions 36.00 net stock cost 5,111.00 x margin rate 50.00 equity required 2,555.50 less premium received (1,825.00) plus option commission 36.00 net margin investment 766.50
DEBIT BALANCE Net stock cost 5,111.00 Less equity (2,537.50) Debit balance 2,573.50 At 50.00 % margin
RETURN IF EXERCISED Stock sales proceeds 5,000.00 Less stock commissions (36.00) Plus dividends 42.92 Less margin interest (546.00) Less debit balance (2,573.50) Less net margin investment (766.50) Net profit - margin 1,120.92 Return % 146.24 % Net yearly return 68.15 %
RETURN IF UNCHANGED Unchanged stock value 5,075.00 Plus dividends 42.92 Less margin interest (546.00) Less debit balance (2,573.50) Less net margin investment (766.50) Net profit - unchanged 1,231.92 Return 160.72 % Net yearly return - unchanged 74.90 %
BREAK-EVEN POINT Net margin investment 766.50 Plus debit balance 2,573.50 Less dividends (42.92) Plus margin interest charges 546.00 Total stock cost to expiration 3,843.08 / shares held 100.00 Break-even point 38.43 :
PERCENT DOWNSIDE PROTECTION Initial stock price 50.75 Less break-even point (38.43) Points of protection 12.32 % downside protection 24.27 %

How about that, Options Trading FAQ?

Love, Me and McMillan

Dear M&M:

I give up! I now dub thee Sir OPTION TRADER. - You can take over the column, I’m staying out on an extended Thanksgiving holiday! Actually, I spoke with my margin clerk, and this is what I learned (I think ):

There are two applicable calculations: 1) the fed call requirement and, 2) the house call calculation. The first is as you have calculated: 50 1/2 for the stock times 100 shares at 50% initial margin is $2525. Then subtract the full proceeds of the option sale (1800) Requirement is $725. So, on the day of the sale, you are correct, only the 725 is needed. Then, after that, (as you have alluded to earlier), the house calculation applies as follows: 30% of the stock (that is when they’ll issue a call), but using the exercise price instead of the current stock price if the option is in the money. This is known as Pegging the stock (to account for the terms of the outstanding contract).

Also, the clerk replied (rather haughtily, I thought) that, for protection, each firm can set their own requirements higher than the minimums set by the exchanges.
Good Work. Now I’ve learned something from this forum too! I’ve got a question for you. Looking to jump into this internet craze, I bought calls in... ;D

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order, Options Margin

The Options Trading FAQ is a reprint of the ground-breaking work done at the dawn of the web age. The generation of option traders that learned the ins and outs of option trading from the usenet will remember these posts fondly.

Copyright 1996 This is copyrighted material about trading options. Do not reuse this text in any manner without permission. This option trading strategy information is valuable and monitored for unauthorized use.