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Educational Article

The Return of the Margin Monster

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By Robert John Ogilvie

An investor may receive a copy of the Characteristics and Risks of Standardized Options by accessing this hyperlink:

http://www.cboe.com/resources/odd/

This article is going to cover the concept of writing uncovered calls. As stated in the previous article, an investor wishing to trade this strategy must be a speculative investor able to take on extreme risk. Uncovered call writing is defined as a short call option position in which the writer does not own an equivalent position in the underlying security represented by his option contracts. This is considered to be very risky because the underlying security can theoretically advance to infinity whereas a short put option can only decline to zero. Generally, the uncovered call is initiated out of the money and at a severe resistance point. This is done because you don't want to sell a call on a stock that you don't own. The reason is that if the stock advances above the strike price, the stock may be sold in your account. And unless you own it, you will be short that stock. In some cases, shorting the stock may work out to your advantage. But only if the stock goes down below your adjusted cost basis.

Just in case you missed the previous article, I will repeat the calculations for the margin requirement. The calculations are in depth. But as investors, you should be aware of how much these positions cost to hold. The margin requirement changes with the price of the underlying security as well as the option sold. In addition, the margin maintenance is set by the brokerage firm and may be higher than the requirement set by the regulatory agency. To determine the margin requirement if the maintenance is 20% and 10%, take the greater of 20% of the current price multiplied by the number of shares less any out of the money plus the premium or 10% of current price multiplied by the number of shares plus the premium. To illustrate, lets assume we want to write 5 contracts of the May '00 130 Calls on an $100 stock. Let's also assume the premium is $2.50. First multiply the stock price ($100) by 1000 (5 contracts X 100 shares per contract) and then by 20% to get $10,000 ($100 X 500 X 0.20 = 10,000). Then add the premium received of $1,250 ($2.50 X 5 contracts X 100 shares per contract). The current total is $11,250 (10,000 + 1,250). Then subtract the amount the stock is out of the money which is $15,000 (130 - 100 = 30 points out of the money X 5 contracts X 100 shares per contract) from the previous number ($11,250). The total is -$3,750 ($11,250 - 15,000). Obviously, they won't let us get away with not providing any collateral. Unfortunately, we have to calculate the 10% method because we can't have a negative requirement. Multiply the $50,000 by 10% to equal $5,000 and add the premium of $1,250 to total $6,250. We have to use the greater of the two calculations, which is $6,250.

This would be a good trade if the stock kept dropping because the margin requirement would decrease and the likelihood of the position expiring worthless increases. However, nothing is set in stone. Lets say for example, the stock drops to $80 and the premium drops to $1.375. The margin requirement reduces to $4,687.50 ($80 X 500 X 0.10 + 500 X $1.375). But what happens if the security bounces up to $135 on the day of expiration? The margin requirement increases and the position is now in the money by 5 points when you only brought in $2.50. Assume the premium is now $7.00 to buy to close. Because the 10% calculation is $10,250 (($135 X 5 X 100 X 0.10) + (5 X 100 X $7)) and the 20% calculation is $17,000 (($135 X 5 X 100 X 0.20) + (5 X 100 X $7)) the margin requirement is the greater or $17,000. That is a large percentage increase in margin liability. If the stock closes at $135, the stock will be sold at $130. That is a $5 loss per share on the stock and a gain of $2.50 per share on the options. The good thing that can happen, assuming you have enough margin available in your account to short the stock, is if the stock drops below $132.50. You would then buy the stock to close out the position at break even or possibly a profit. The bad alternative is if the stock gaps up $5 points on the following Monday. Now you are down a total of $10 less the $2.50 in premium. Most investors close out the uncovered call when it breaks the strike price. Some investors close out the position when the premium to close the position is twice that of the premium received ($2.50 x 2).

The point at which an investor decides to close out the position depends upon the investor's risk tolerance, objectives, goals, speculation level, future outlook on security, etc. An alternative to uncovered call writing is the Bear Call Spread or the Call Credit Spread. This provides some upside protection against the stock. I will embellish on this strategy in my next article. If you have any additional questions regarding this article, please feel free to contact me at the e-mail address below.

Robert John Ogilvie

Neither Cutter & Company, Inc. nor Robert J. Ogilvie makes any representation as to the accuracy, reliability or completeness of any charts, formulas, and /or research opinions presented herein. This article is intended solely for educational purposes. Nothing herein should be construed as an offer or solicitation to buy or sell any securities. Cutter and Company is a Member of the NASD, MSRB, and SIPC. Please read the OptionInvestor.com's Disclaimer.

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