Have a single-leg option? Consider using a vertical spread to turn it into a defined-risk spread to lower the margin requirements and free up capital at the same time.
Let’s say you’re short a single-leg put, and the market has been chopping along, maybe grinding higher. Unless implied volatility has been steadily climbing, you’re probably sitting on a theoretical profit. Getting nervous about whether your good fortune might continue?
And what about the capital you’ve been tying up? Unless you have full options approval (more on that in a bit), your margin requirement is quite high, because it involves having at least enough capital in your account to cover the purchase of the stock, should you get assigned (This is called a “cash-secured” put). And remember: A short option can be assigned at any time up until expiration regardless of the in-the-money amount.
Looking for a way to protect your current position without giving up too much of your potential profit? There’s a way. And in doing so, you’ll get the added benefit of a substantially lower margin requirement, which can give you some extra options buying power—while taking some of the risk off the table.
The strategy: Turn it into a vertical spread by buying a lower-strike put.
The high margin requirements for selling cash-secured puts makes them quite capital intensive. And though its risk is technically “defined,” it’s defined by the strike price—the price at which you’d be required to buy the stock if you’re assigned—and zero. But with most stocks, and particularly with the many high-priced tech stocks popular with investors these days, it can be a long way to zero.
Side note: If you’re ever thinking about selling a naked call, the risk profile is even more open ended. The maximum loss potential is infinite, to be exact. For that reason, many accounts don’t even qualify.
Perhaps it’s time to think vertically.
By definition, a call vertical spread is long one call option and short another call option at a different strike price in the same underlying asset, in the same expiration cycle. Similarly, a put vertical spread is long one put option and short another put option at a different strike price in the same underlying asset, with the same expiration date. Usually both legs of a vertical spread are established simultaneously, but you can create the same position by buying an option that’s further out of the money than the existing short options position.
First, let’s see a graphical illustration of two risk profiles—the cash-secured put and the short put vertical spread (see figure 1)—followed by an example with numbers. And not to worry: The math is pretty straightforward.
FIGURE 1: RISK PROFILES OF A SHORT PUT AND SHORT PUT VERTICAL SPREAD. Note that buying a lower-strike put turns a short single-leg put into a defined-risk spread. For illustrative purposes only.
Let’s say a week ago you sold a 134-strike put option for $1.10, and now it’s trading at $0.83. The position has been working in your favor, but you’d like to reduce your risk and lower the margin requirement without closing the position.
In this case, you could buy the 130-strike put for $0.25, which would create a 134/130 short put vertical spread, for a net credit of $0.85. That’s calculated by taking the original $1.10 premium you received a week ago, minus the $0.25 premium paid for the 130 put. The net risk of a short vertical spread is the difference between the two strikes minus the net premium—$4 minus $0.85, or $3.15. And remember to include the multiplier for standard U.S. equities (see sidebar, “Remember the Multiplier!”) as well as transaction costs.
In summary: ((134-130) - ($1.10 - $0.25)) x 100 = $315 in risk and a potential profit of $85 (minus transaction costs)
Non-standard options may have different deliverables. Make sure you understand the terms before trading.
The original margin requirement for selling a 134-strike cash-secured put is its strike price, less the credit received, times the multiplier, or:
($134 - $1.10) x 100 = $13,290. The new margin requirement for the short 134/130 put vertical spread is the difference between the strikes x $100, or: (134-130) x $100 = $400.
In this example, turning the cash-secured put into a put vertical spread lowered your potential profit by $25, but reduced your margin requirement by a whopping $12,890 per contract.
Without full options approval (“Level 3”) in a margin account, you can’t sell naked puts, and instead must sell puts that are cash secured, which, as you can see from the above example, is capital intensive. By the way, selling cash-secured puts requires Level 1 options approval or higher. The margin on one cash-secured put is determined by multiplying the strike price of the put by $100 and subtracting the credit received.
Naked calls cannot be sold without full options approval because of their infinite risk. Stocks or other underlying assets have unlimited upside—theoretically, they could rise to infinity. This risk is transferred to short naked calls because they’re unhedged. For more on account choices, and to decide which level (if any) of options approval may be right for you, log into your account at tdameritrade.com and under the Client Services tab, select Help Center > Investing Choices > Options, and under The Basics, select What options levels does TD Ameritrade offer?
Capital preservation and capital efficiency are two cornerstones of options trading. By vastly reducing a margin requirement, you’re making funds available for your next trading opportunity. The intensive capital requirements associated with selling naked options can even be cost-prohibitive for those with margin accounts and full options approval.
So, the next time you’re short a single-leg option and are looking for some extra options-buying power, think about turning your short option into a defined-risk vertical spread.
Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details.
Cash-secured put and naked put strategies includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
Spreads and other multiple-leg options strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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