As we have learned, options represent the contractual right between two parties on an outcome that deals with money. Options are considered zero-sum, and there's always going to be one side that's the winner and the other side that's the loser. The amount that is lost by one party and gained by the counterparty will always add up to $0.
When the market changes rapidly and the price of stock options starts doubling, there will always be a concern around if both parties will hold true to their promises. We've seen what happens when large institutions like banks fail to meet their promises. One such case led to the subprime mortgage financial crisis of 2008.
How do we know that we'll be able to collect the profit owed on our options?
The clearinghouse requires margin to be posted for all options traders. Margin is used as insurance to make sure that everyone gets paid at the end of the day. There are two forms of margins that can affect options traders. To make things a bit more complicated the margin required for the writer, the original seller, of an option is much higher than for buyers. Let's step through some examples of margin.
Buying call or puts
We've learned that when we buy a put or call option, the most we stand to lose is the full premium paid for our options contracts. Since we've already paid, we are not on the hook for anything additional. If we used margin to pay for options premiums, there's a caveat. In this case, we are borrowing money against our account to place risky bets on options, and this is usually a recipe for disaster. We should always avoid buying options on margin.
Having in-the-money call options at expiration can be a good thing. If our account is not approved for margin, typically the brokerage will sell our options on our behalf within the last hour of the maturity date. However, if we are approved for margin, our brokerage will lend us money to auto-exercise our in-the-money options. This could work in our favor if the stock price continues to go up, but it can also wipe out our hard-earned gains if the stock drops in price.
New options traders have made the mistake of accidentally selling a call option when they had meant to buy instead.
While this mistake seems small, it can trigger a big margin call. Typically, most brokerages will not allow us to write options unless we have level 2 options clearance and approval for margin. Writing a call option is one of the riskiest strategies we can do because we are essentially promising the buyer of the option the right to buy 100 shares at the strike price. If we don't own 100 shares, the brokerage account will use margin to make sure we can buy 100 shares on the market.
We can see the example above that losses rack up very quickly due to our leveraged exposure. Options grant us leverage because one contract allows us to benefit or lose as if we owned 100 shares. Leverage greatly magnifies potential gains in exchange for magnifying the risk we take.
Margin is a helpful tool when used properly. Not understanding the risks that options introduce to margin accounts often leads beginners into unfortunate circumstances. While financial regulators do their best to safeguard everyday investors by enforcing rules, it's ultimately up to us to be able to protect ourselves. This starts by understanding what we are buying and selling before we actually take the steps to do so. Help your family and friends learn about the risks of options and margin by inviting them to the app.