The Price of Being Naked

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

There are quite a few option strategies that involve selling options “naked” – that is, selling options without having any position in the underlying asset. In the case of selling puts, naked means also not having 100% of the cash in the account that would be required to pay for the stock if assigned. (If we sold puts and we did have 100% of the cash required, then the short puts would not be naked – they would be “cash-secured”).

When we sell naked options, we are required by the options exchange to put up security in case the trade goes against us. Individual brokers may then add additional rules if they feel they need more protection. The reason for the margin requirement is that by selling an option, we have obligated ourselves to buy stock we may not want (if we sold puts), or to sell stock we don’t have (if we sold calls). In either case, that obligation could potentially result in our having to take a large loss on the stock. If we can’t handle that loss, our broker will be on the hook, and ultimately the exchange would have to make it good if our broker failed. So they require that we put up security.

The rules seem kind of obscure at first glance, but they’re really not hard to understand when we dig into them, so here we go.

Here’s the margin requirement for uncovered (“naked”) short options, from the Chicago Board Options Exchange’s Margin Manual:

1. 100% of option proceeds,
2. plus 20% of the underlying security’s value,
3. less the out-of-the-money amount, if any,
4. with a minimum for calls of the option proceeds plus 10% of the security’s value,
5. or a minimum for puts of the option proceeds plus 10% of the put strike price.
6. Some brokers add to these rules: Tradestation, for instance adds “or $250 per contract, whichever is greater.”

Yikes. What does this mean? Here’s the breakdown.

First, the margin requirement always includes “100% of option proceeds.” So the clearing house initially keeps everything we get from the sale of the option – we don’t get to spend it while the option position is in place.

After that, the rules differ slightly for puts vs calls. Puts are the simpler case.

For puts, we need to provide money from our own funds of 20% of the of the stock’s value; but we can deduct from that requirement the amount that the put is out of the money. If deducting that OTM amount takes the requirement down to less than 10% of the put strike price, then 10% is the number. Finally, for Tradestation and some other brokers, a minimum dollar amount is imposed. Tradestation makes the minimum at least $250 per contract ($2.50 per share).

Here’s an example: Stock at $100, 95-strike put at $2.

We would not get any of the $2 put premium initially – it is the first part of the margin requirement.

In addition, we have to calculate 20% of the underlying price. 20% of $100 is $20 per share.

From this $20 we can subtract the amount by which the put is out of the money. This is $5 ($100 stock price less $95 put strike). $20 less $5 leaves $15.

Since $15 is more than 10% of the $95 strike price, $15 is the amount of our money that would be required. Selling the put for $2 costs us $15 of our own money in margin.

How and when do we get our $15 back?

That happens when the position is closed out. There are only a few ways that can happen.

1. We could buy the options back prior to expiration, at a profit. Say the stock does not drop, and the value of the put option deteriorates. A few weeks later, it is quoted at $.05 per share. We buy it back for 5 cents per share. We then get back our $15 margin, plus the $2 original premium. Deducting the 5 cents from the $2 premium, our profit is $1.95 per share, and our margin is back in our account.
2. We could buy the options back on or before expiration day, at a loss. Say the stock drops to $90, and the put option is quoted at $5.00 per share. We buy it back for $5.00. This $5 cost amounts to the $2 we were originally paid, plus another $3 that comes out of our own $15 in margin. We get the remaining $12 of our $15 margin back, and are $3 poorer.
3. The option could expire with no value. Once the expiration date has passed, our $15 plus the $2 premium is released to us, and we are $2 richer.
4. The option could be assigned. This means that after we sold the option, some put owner decided to exercise one of those puts. The put owner tenders his stock, and receives payment from the clearing house equal to the put strike price ($95 per share). The clearing house then selects a put seller at random to be assigned – that is, to be forced to buy the stock. If that’s us, then we receive the stock, and the $95 per share strike price is deducted from out account. After taking out 100% of the money required to buy the stock, the clearing house then credits us back for our $15 margin plus the original $2 put premium. At this point, we may have either a profit or a loss. We will now own the stock, and our cost will be the $95 strike price we were forced to pay, less the $2 we received as premium for the put. That’s a net cost of $93 per share. If we can sell the stock for more than $93 we win, otherwise we lose.

Note that while the short put position was in place, before any of the above four eventualities occurred, it’s possible that we would have been required to put up additional margin. Any increase in value of the put after we sell it will result in additional margin being required. The house needs a 20% buffer to be maintained at all times.

For short calls, the margin rules are similar, with one exception: the 10% minimum margin is applied to the stock price, rather than the strike price. Note that the sky is the limit on the loss on naked short calls, since the stock could go up to any price.

When all is said and done, a simple rule of thumb is to figure on 20% of the strike price for short puts, or 20% of the stock price for short calls, and expect to pony up more if the trade goes against you.

Now, wasn’t that easy?