Tag Archives | margin requirement

Can you believe this?

What some brokers do

I recently read a trader’s lament in an online form. It turns out that his broker forbids him from buying options on an unspecified day during of expiration week. Why? Because if he still owns the calls at the close of trading on Friday, he would not have enough cash in his account to meet his margin requirements if the options were exercised.

I’ve heard that at least one other broker enforces the same rule, but at least they allow their customers to buy options from Monday through Thursday of expiration week.

This practice is nothing short of stupidity in action. There is no rational reason why customers should be prohibited from trading.

This firm willingly granted him clearance at the appropriate permission level to buy and sell calls and puts. It now seems that the permission is strictly limited and only available to certain customers on certain dates. If their customers do not have enough cash to exercise the options, this firm does not trust the customer to exit the trade in a timely manner.

It now seems that ‘permission to buy options’ now depends on how much time remains before the options expire and how much borrowing power is available to the customer.

Isn’t this why many investors trade options? They don’t have the cash required to trade the shares, so they own options instead. It’s called leverage and reduced risk. This firm does not allow a customer who had $50,000 in his account to buy a 10-lot of calls for a quick trade. That’s all this customer wanted to do: Hold the position for a very short time. However, because buying 1,000 shares would cost more than this customer can borrow on margin, the call purchase was forbidden.

It is beyond belief that any customer would accept this. To his credit, this trader accepted the denial of trade and the lament was his way of asking whether anyone else had seen that happen.

As a disinterested reader of the forum post, I was horrified. I recognize that the brokerage firm must protect itself against customer losses that cannot be recovered, but this specific ruling startled me.

Weeklys

Weeklys options have become a star attraction, as many traders love the idea of playing with short-term options. I don’t know if this firm blocks everyone who lacks sufficient buying power from trading Weeklys, or whether this individual was singled out for a specific reason. It would not be a wise business decision to forbid a significant portion of your customers from trading in Weeklys.

Protecting the broker

The brokerage firm has other methods to protect itself from the possibility that this, or any, trader would incur a margin call that he cannot meet. For example:

  • If trader the calls one hour prior to the market close on Friday, liquidated the position
  • Trader must submit ‘Do Not Exercise’ form no later than (pick a time) on Friday, or else options are sold
  • If trader fails to sell calls, firm locates broker-dealer and sells short 100 shares per call.
    • If the fill is not at a good price, I’m certain that the firm could not care less

To me, these are three viable alternatives to prevent the firm from incurring risk. At this point it seems fair to ask, just what is that risk? How bad can it be for the firm would to take such drastic measures to protect itself?

For the firm to suffer a substantial loss, these items must occur:

  • The trader must forget to to close the ITM option position
  • The stock must undergo a large price gap (in the wrong direction) on Monday morning
  • The gap must be large enough to place the customer account into deficit
  • The customer must be unable to re-pay that debt
  • The customer must have so little remaining assets that the firm cannot recover via lawsuit

I don’t believe there is a person on this planet who deems this to be an event with any reasonable chance of occurring. I agree that the firm wants to avoid even this much risk, but it has better ways to accomplish that task than by preventing a customer from making a trade.

Brokers have dissed their customers for decades. I never thought it would reach this level.

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Wider Iron Condors

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A recent comment from a reader (Logan) suggested a worthy topic.

Choosing strike prices for any option strategy is important.  Most traders have a method for doing that, such as using charts (selling calls above support and puts below resistance) or statistics (selling options that are a specific number of standard deviations OTM).  Alternatives include selling options within a specific delta range, or perhaps a minimum premium.

Question for credit spread sellers (and iron condor traders): If you always sell 10-point spreads, have you looked at the idea of selling 20- or 30-point spreads? 

NOTE:  Spread width is the distance between the two options that comprise a credit spread.

Equivalent trade

Let's be certain we all understand the position when a wider spread is sold.

Example: GOOG iron condors (Trade itemized is a randomly chosen example.  Please do not consider it to be a recommendation)

Your customary choice is to sell 10-point spreads, using GOOG

Sell 10 GOOG Aug 510/520 call spreads; premium = $1.90

Sell 10 GOOG Aug 450/460 put spreads; premium = $1.30

Trade: Collect $3.20 for 10-point GOOG Aug iron condor

As an alternative, you are considering the 20-point iron condor

Sell 10 GOOG Aug 510/530 C spreads; premium = $3.00

Sell 10 GOOG Aug 440/460 P spreads; premium = $2.30

Trade: Collect $5.30 premium for 20-point iron condor

This may be obvious to experienced traders, but if you never thought about it, or if you are new to options trading, then this simple conclusion may be news to you:

When you own the 20-point iron condor, your position is exactly the same as if you bought each of the two 10-point iron condors.

NOTE:  If you prefer to own the wider credit spread or iron condor, please do not buy each of the more narrow spreads.  Just buy the position you want to own when entering the order.  This is very important because it cuts commissions in half and guarantees better fills (half as many bid-ask spreads to overcome).


In our example, 10 GOOG Aug 510/530C; 440/460P iron condors @ $5.30

is equivalent to

10 GOOG Aug 510/520C; 450/460P iron condors @ $3.20 PLUS

10 GOOG Aug 520/530C; 440/450P iron condors @ $2.10

Thus, if a 10-lot is your correct position size, then 5-lots of the wider iron condor uses the same margin and has the same risk as owning 5 of each of the narrow spreads.


Why is this important?

  • Size.  Owning one double-width iron condor is equivalent to owning one each of two different narrower positions.  Thus, when trading a double-width position, the correct size is HALF your usual size.  This is very important for risk management. 
  • 20-point spreads allow the trader to own two iron condors simultaneous
  • If the CTM (closer to the money) position is near the borderline of your comfort zone, one way to minimize that concern is to cut position size in half and add an iron condor that is one strike farther OTM on each side.  Note, this does not remove the risk associated with the CTM position, but averages that risk with another iron condor.  In other words, you have 5 CTM and 5 farther OTM iron condors.

I always trade and describe the narrow iron condor.  However, there are advantages to the wider position.  In the example, we traded one iron condor, collecting a premium of $320 and another collecting $210.  For most traders, that farther OTM, lower premium iron condor is less risky to own from the point of view that it is less likley to lose the maximum.

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I'm very proud of The Rookie's Guide to Options.  Unsolicited comments offer almost unanimous praise.  If you are seriously interested in learning about options, this is the book for you.  For the beginner, but it contains much material not discussed elsewhere, and is appropriate for intermediate traders as well.

 


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