Traders especially new traders must always be aware of the fact that Option involve risk and are not suitable for all investors. Please keep this in mind, when you begin to put on trades.
Now, with that in mind, it’s important to know that one of the big draws for investors looking to trade options is the margin relief offered when trading such products. Sounds simple. Right? So, how do we put this in a workable context?
Well, the first thing to think about is a term called notional value.
To be quite honest it took me awhile to internalize the idea of notional value. I don’t know why exactly. It was just one of those terms that couldn’t find a place to sit in my brain. Anyway.
The notional value of a position is the real amount at risk, excluding margin relief. For instance, If we own 100 shares of stock at $50.00 per share, we have $5000 of notional value at risk. If the stock price drops to $0.00, we stand to lose $5000.
Without margin, we need to put up the full $5000 to buy those 100 shares of stock. 200 shares requires the full $10,000.00, etc. In a margin account, we are offered 2:1 leverage on stock purchases.
What does this mean?
Basically, that same 100 shares of stock would only require $2500 of capital to purchase. What we have to remember is that we still have that same $5000 of notional value. In other words, we only have to put up $2500 at first, but if the stock price goes to $0.00 we still lose $5000. Understanding the difference between leverage & notional value is one of the most important concepts to learn. Leverage just enables us to put up less money to buy shares than a cash-secured account:
Leverage comes in all shapes and sizes. More leverage can give us a higher return on capital, as we’re not required to put up as much, but it can also magnify losses quickly. Understanding leverage and how we can use it is imperative for futures, options, and stock traders alike.
Leverage in Options
When it comes to options, leverage works a little differently. Unlike stock, available buying power doesn’t change. If we deposit $10,000 into my account, our option buying power will be $10,000. If we are in a margin account, the stock buying power will be $20,000. That is how the stock leverage works.
If we’re in a margin account and have full margin for options, the difference lies in the buying power reduction (BPR).
Let’s say we sell a put at the $50 strike, when the stock price is trading at $55.00. In an IRA account, which is cash secured and has no leverage, we are required to put up $5000, less the credit we receive for selling the put. Each put contract has the theoretical equivalent of 100 shares of long stock, which is why the shares are already accounted for when selling the put.
However, in a margin account, we are required to put up a fraction of the total value. In a lot of cases the amount required may be around 20% of the strike (around $1000 in this case). If I have to put up only 20% of the notional value for a trade, then I may be thinking I could put on 5 trades instead of one. This can be a very risky approach. It is possible, but, I don’t recommend it. Depending on the stock price, 5 – at the money strike puts could have a buying power requirement of only $5000.00, but the notional risk could be 5x that amount.
There are a few different calculations the brokerage works through, and they choose the highest value of those calculations for BPR. This is where leverage plays a role. We are only required to put up $1000 initially, but we still stand to lose $5000 less the credit received if the stock price goes to $0.00. This is why we always keep a lot of cash available in our portfolio, as these margin requirements can change by the minute.
One of the 10 Pillars of trading followed by the traders at tastytrade is Trade Small and Trade Often. And leverage allows you to do just that. But you have to be prudent and not over leverage and take on more risk than you can handle.
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