If you're just changing from standard long call or put options trades, you're accustomed to knowing exactly how much money you have at risk. That amount is the amount you spent buying the options. It's relatively easy to keep track of that risk.
If you always know how much money you have invested in options, you also can make easy judgments about how much of a cash cushion you need. That cash cushion ensures that your account isn't wiped out if something unforeseen happens. It also provides you with the money you might need if another tempting trade comes along.
Once you venture into combination options trades, the need for a cash cushion might escalate. At the same time, it might prove more difficult to know exactly how much of a cash cushion you need or want. Since most of my live trades are iron condors right now, I'll use iron condors to demonstrate some of the concerns, but the principles mentioned here apply to lots of combination trades. These examples are not representative of my own trades because I tend to be much more conservative in the amount of a cash cushion I leave than our hypothetical trader is going to be. However, I have heard of subscribers setting up their portfolios as I'm going to demonstrate, running into the problem that will be illustrated, too.
Imagine that a trader has a $42,000 account and decides to use $38,000 for iron condors, leaving $4,000 as a cash cushion. The trader decides on 20 contracts of a RUT iron condor and 20 of a SPX one. For those unfamiliar with an iron condor, the position consists of a short (sold) call and short put, hedged by a further out-of-the-money long call and put. For example, although I'm out of my income AUG iron condors for a profit, my RUT AUG iron condor was initiated by selling AUG 600 calls and AUG 380 puts. To hedge the risk, I bought AUG 610 calls and AUG 370 puts. Because the closer-in sold puts and calls are more expensive than the hedging long puts and calls, the iron condor brings in a credit that is deposited in the account. The call part of the iron condor is sometimes called a bear call credit spread, and the put part, a bull put credit spread. I'll be using those names later in the article, but if you don't understand how an iron condor works, don't worry. Just read to determine the outcome and potential problems with this setup.
The trader receives a credit for this position, but additional money is held as maintenance/margin dollars in the account. This trade has an impact on the buying power. That buying power effect is fairly easy to calculate, too, if you have a Regulation T account and don't have customer portfolio margining. First, the trader figures out the total credit received for the trade. For the sake of this article, let's imagine that the trader brought in $1.20 per contract for the RUT iron condor after commissions and fees. Since the trader had 20 contracts, that's 20 x $1.20 x 100 multiplier or $2,400. That money is deposited in the trader's account.
The risk also needs to be calculated. Most brokerages assume that only one side of an iron condor will go bad, so they hold maintenance/margin dollars against only one side. Check with your brokerage, though, to verify their policy since a few brokerages still hold maintenance/margin dollars against both sides. For our hypothetical trader with the $42,000 account, let's imagine that this trader is with one of the progressive brokerages that holds money against only one side. That risk, then, can be calculated by first determining what would happen if the RUT had gone all the way straight to 610 and stopped there at August's expiration. The 600 call would be worth $10.00 and the 610, nothing. The iron condor trader would owe $10.00 for the call that was sold and would collect nothing for the one that was bought.
Therefore, the risk for the 20 contracts would be 20 x $10.00 x 100 multiplier = $20,000. Ouch! Wait a minute, though. That trader took in $2,400 after commissions and fees, and that credit is sitting in the account, so the risk is actually $20,000 - $2,400 = $17,600, and that's what the brokerage will withhold as maintenance/margin dollars.
If you imagine that this trader took in the same credit after commissions and fees on the SPX iron condor and that there was also a 10-point difference in the sold and long calls and puts, then the trader had another $17,600 withheld for that position. For both the RUT and SPX iron condors, $35,200 in maintenance/margin was withheld in this hypothetical trader's account. The trader had $6,800 left in the account as a cash cushion. That trader was ahead of the plan. That's more than 16 percent of the account balance.
But was that trader in a good place? Was 16 percent enough of a cash cushion? Imagine that markets zoomed higher. That hasn't been hard to imagine lately, has it? In our hypothetical situation, imagine that the sold strike on both the RUT and SPX positions were close to being violated. The trader decided to close the positions in the fear that the RUT and SPX were just going to keep charging all the way up through the sold strike and to or through the long strike, which would mean the trader would incur a $35,200 loss.
There's a problem. Let's look at the RUT first as an example. If that hypothetical trader decided to buy back the 20 sold calls and sell the 20 bought calls, there's going to be a cost. For example, as this article was roughed out about a week ago, to buy back a RUT 10-point spread when the RUT was still about 22 points away from the sold strike cost about $2.20 per contract after commissions and fees. The closer the RUT approached that sold strike, the higher the cost would get. Imagine that it would cost another $.25 to close the put side, the bull put credit spread, and, with the markets zooming, the trader didn't want to pay that much to close that side of the iron condor. The trader thinks that in a day or two, that side could be closed for a much smaller debit. The total debit to close the call side of the position, the bear call credit spread, is then $2.20 plus commissions and fees. That would be 20 x $2.20 x 100 = $4,400.
Let's imagine that, at the same time, the trader decided to close the call side of the SPX trade. It's getting into trouble, too. The SPX one is probably going to be more expensive to close, and it's getting more expensive by the moment. At the time this article is being roughed out, it would have cost about $2.35 after commissions and fees to close an SPX spread at about the same delta level, which many traders using deltas to make those decisions. Furthermore, in a fast-moving market, it might have cost even more and probably would have, with the SPX trades sometimes a bit more difficult in a fast-moving market. Assume that, in this case, the other side of the iron condor would cost a $.25 debit to close, and the trader doesn't want to pay that much to close that other side. The trader decides to put the order through to pay a debit and close the bear-call-spread side, the call side of the iron condor, at the same time that the order to close the RUT iron condor is still working.
There's trouble. The trader can't put both the SPX and RUT orders through at once.
Why? The total debit for closing the SPX position is $2.35 per contract. With 20 contracts, that's 20 x $2.40 x 100 multiplier = $4,800. However, because the trader is closing out only one side of the RUT and SPX traded, the brokerage is still going to withhold the maintenance/margin dollars for the opposite sides of both the trades.
The cost to close the call sides on both the SPX and RUT positions at once would be $4,400 + 4,800 = $9,200. Remember how much cash cushion the trader had in the account? It was $6,800. That's not enough, not when the brokerage is holding maintenance/margin dollars and will continue to do so against the put side of both trades, the bull put credit spreads, that are still open. Remember that the brokerage is holding $35,200, $17,600 for each of the iron condors, and it will continue to hold $17,600 for each until the position is closed. The two orders can't go through at once.
Whether the trader wanted to do so or not, that trader would now be faced with closing both sides of at least one of the iron condors to lower maintenance/margin withheld. Furthermore, the trader perhaps would have to wait until that trade went through before putting in the other order, too, depending on that trader's brokerage rules. The other trade would be getting more expensive to close all the time as markets continued to move against the trade. The loss would be bigger than wanted or anticipated, and some of the trader's choices would have been removed.
I used a portfolio full of iron condors as an example because the maintenance/margin dollars are easy to calculate on a Reg T account. I also chose that because many subscribers trade them, too. However, other positions such as butterflies and calendars can sometimes be easily adjusted if the trader can add a second butterfly or calendar, but that can occur only if there's enough free cash in the account.
How much cash is enough? I leave at least 30 percent in calm market times, when I don't anticipate as many adjustments, and more in more volatile times, when I anticipate a lot of adjustments. Talk to your broker about the types of strategies you're employing and how that might impact your decision.
You can use every penny of your account for options positions, but you certainly don't want to do that. You want to leave enough of a cash cushion to provide for two needs: cash needed for adjustments or hedges and just-in-case money that won't be touched, so that if something unforeseen happens, you always have an account with which to begin again.