by Amanda Harvey
Margin and option trading may have a different relationship in different circumstances, but basically margin refers to the initial capital that must be deposited and the balance that must be maintained in a margin trading account. For a day trading account, this amount is $25 000USD, and this balance must be present in the account prior to the start of a trading day in order that the trader be allowed to conduct day trading. This capital may include not only cash, but also marginable securities such as stocks which are considered collateral.
One thing to keep in mind is that the value of these marginable securities fluctuates, meaning that if securities have dropped in value, the trader will need to add funds to maintain the margin requirement. If the balance in a margin account falls below the minimum level, the trader will be issued with a margin call, which is a notification to restore the balance to the required amount. The trader then has a maximum of five days to address the shortfall.
Margin and option trading has particular relevance when it comes to choosing the type of trading account that is suitable for your trading profile. Two scenarios when margin is most relevant to options trading are in the cases of either selling or writing options, or when trading options as a day trader or pattern day trader. Most day trading is conducted through a margin account, as according to Finra, “Day trading in a cash account is generally prohibited.”
A benefit available through the use of margin and option trading is the leverage of increased buying power offered to day- or pattern-day-traders through the use of borrowed funds. The difference between these two types of day trading is primarily based on the number of trades conducted within a five day period, with the criteria for pattern day trading being the completion of four or more day trades within this time frame, and the capital investment in these trades accounting for no less than 6-percent of the trader’s total investment within the same period.
If a trader is using a day trading margin account, but has not been classified as a pattern day trader, then he or she is eligible to use twice the excess value in the account for buying options, and this value is assessed at the close of trading on the previous day. If classed as a pattern day trader, the trader may use up to four times the available capital. Interest is charged based on the amount of borrowed capital used in entering trades, and these rates vary among brokers.
Not all traders choose to use the maximum amount, or even any of the available margin credit for purchasing options. It is available to them, but they may choose to use only or mostly their own available capital, thereby avoiding interest charges, and lowering their risk.
Margin and option trading in the arena of selling options can be a complicated matter, especially when selling options on stocks that a trader does not actually own. In the event that the stock price goes the opposite way to what the trader expected, they may have to buy the stocks at a price that is much higher than what they will then receive from the holder of the options contract who chooses to exercise the right to purchase from the seller at the agreed upon price stated in the contract. One of the most important things for a trader involved in writing options to do is to make sure that they have sufficient funds available to cover unfavorable outcomes and to maintain margin requirements.
Especially for traders wishing to engage in day trading, or in the selling of options, margin and option trading go hand in hand. Whether you use a margin account simply for the ability it gives you to conduct day trading, or you also wish to take advantage of the greater purchasing power that is offered by using margin credit, a margin account that is carefully managed and wisely used can be of great benefit to a trader.