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Selling puts on margin is an advanced trading strategy that combines the benefits and flexibility of options trading with the additional leverage of margin.
This approach can help traders generate income and diversify their investment portfolios, but it’s essential to understand the margin requirements and associated risks. In this article, we will explore the concept of selling puts on margin, explain how it’s done, discuss margin requirements, and highlight both the advantages and the potential downsides of this strategy.
Definition of Selling a Put on Margin
To understand selling puts on margin, we must first explain the basics of selling a put option.
A put option is a contract that gives the option buyer the right to sell a specified amount of an underlying asset, such as a stock, at a predetermined price (the strike price) before a specified expiration date.
As the seller of a put option, you receive a premium from the buyer for taking the other side of the trade.
Still, you must buy the underlying asset at the strike price if the buyer chooses to exercise the option.
Selling a put option on margin means that instead of using your own capital to cover the entire potential obligation of purchasing the underlying asset, you use borrowed funds from your broker.
This leverage allows you to control a larger position than otherwise. This is a huge benefit if your options expire worthless, but it can also significantly amplify the losses you could have.
How to Sell Puts on Margin
To sell puts on margin, you need to do the following.
First, open a margin account with your broker or upgrade your cash account to the necessary level.
If you already have a margin account, contact your broker to ensure you can sell puts on margin.
Next, you need to review your broker’s margin requirements to ensure you have the correct funds for the initial and maintenance margin requirements.
After that is complete, you are ready to sell a put-on margin with your broker.
Next, you can research a stock you believe to be undervalued and look for a future-dated put at a strike below the current price.
Once that is complete, you would simply execute the sell order.
Some brokers automatically execute it on margin if you have a margin account.
In contrast, others will require you to select how you want the trade to execute (on cash or on margin), so be aware of any special actions your broker may require.
Keep an eye on the underlying and be prepared to take action to ensure you maintain compliance with your broker’s requirements.
Margin Requirements for Selling Puts
It is essential to follow your broker’s margin requirements when trading.
Ignoring your broker is the quickest way to lose money when using margin.
Brokerage firms may have different margin requirements, but they usually include the following: first, a minimum margin requirement.
This initial margin requirement will depend on the instrument you trade.
The initial margin is a deposit to cover any potential fluctuations or losses on a position.
This typically represents a percentage of the total value of the position, usually between 20% and 50% of the total position value, depending on the stock’s volatility.
Second, maintenance margin requirements require traders to maintain a specific minimum account balance while their position is still open, in addition to the initial margin deposit.
A margin call could occur if a trader’s account equity drops below this level.
When this happens, more money must be added to the account, or the position must be closed to stay compliant.
Once you know all the information above, you need to calculate how much you will need in your account to satisfy the requirements.
The following is an example of how to do that calculation:
Let’s say you want to sell a put on a $25 stock and collect $1.50 in premium on a $20 put. Your broker has a 30% initial margin and 20% maintenance requirements.
You would take the $20 strike X 100 Shares per contract X 30% and get $600. Once you open the position, you must maintain a balance of $400 to be within 20% maintenance compliance. ($20 Strike X 100 Shares X =20%) If the account balance closes below the 20% required, you may be asked to deposit more.
Advantages of Selling Puts on Margin
Selling puts on margin offers several potential benefits for traders:
First and perhaps the most important is the potential for higher returns.
By leveraging your capital up through margin, you can control a more significant position with a smaller investment, which may result in higher returns on your initial capital if the trade works in your favor.
The second is using leverage to create more income for your account.
Selling puts on margin can be a fantastic way to generate outsized income for the capital you put in.
This can be an attractive strategy for investors looking to create an income stream or supplement their existing portfolio returns.
Risks of Selling Puts on Margin
As with all things, there are potential risks associated with selling puts on margin.
Here are a few of the risks:
First up is the leverage itself; the same leverage that helps to amplify your gains also helps to amply the losses.
Next is related to the first risk, that’s a margin call.
If your account falls below the maintenance margin requirement, you may receive a margin call requiring you to deposit additional funds or face forced liquidation of your position. Forced liquidation can result in additional losses and may occur at an unfavorable market price.
With margin, your potential losses are not limited to what you deposited into the account.
Finally, the last risk is more of a general downside, and that’s the mental cost of the leveraged position.
Like your brokerage account, the margin will amplify your emotional account.
If the position is going against you, you may incur more stress than normal, knowing you could be required to deposit more money.
Equally as dangerous is the euphoria that comes from nailing a trade on margin. It gives you the thought that you can’t lose.
Risk Mitigation Strategies
The risks mentioned above are not unavoidable; however, they may seem severe, but with some of the following strategies, they can be mitigated and make margin loans a power tool for your trading.
The first strategy is not just for trading on margin but should be for all trading, and that’s position sizing.
As a trader, you should limit the size of your put-selling positions relative to your overall portfolio.
By keeping individual positions small and manageable, you can reduce the potential impact of a single losing trade on your overall account balance.
Another strategy is diversification.
By adding other position types and asset classes to your portfolio, you can help level out the ups and downs of the market.
This helps both mentally and financially.
Mentally you will not see wild swings, which will help with your confidence in trading and managing positions.
Financially it will help smooth out the drawdowns and keep you inside the margin requirements of your broker.
Finally, there is using stop-loss orders.
Although stop-losses are not bulletproof, they can help limit potential losses by automatically closing out your position if the underlying stock’s price reaches a predetermined level.
Be aware that stop-loss orders may not always be executed at the exact price you set, particularly during periods of high volatility or low liquidity.
With options, there are also two ways to set a stop loss, the first is the options price, and the second is the price of the underlying. Knowing which type is best for your trading will also help.
Tying It All Together
Selling puts on margin can be a valuable addition to an experienced trader’s toolkit, offering the potential for higher returns and the ability to generate additional income.
However, it’s essential to understand the risks associated with this strategy, including the possibility of significant losses and the need for constant monitoring.
By carefully considering the risks, employing risk-mitigation strategies, and following your broker’s margin requirements, you can enhance your chances of success while minimizing potential risks.
Just make sure you have a good understanding of what margin is before you commit to trading with it.
We hope you enjoyed this article about selling puts on margin.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
In the article “Selling Puts on Margin”, it is stated that selling puts on margin entails trading on money borrowed from the broker. Does it mean that such trading involves interest expense to be paid to the broker?
Yes, that’s right, you would have to pay margin interest to the broker for any borrowed funds used.