Portfolio margin: The rules behind leverage
While margin trading can provide you with leverage, that leverage may at times work against you, placing you in a margin call. When this happens, you’ll be placed in “liquidation-only” status and it’s important you understand what actions you can take while in this restricted status.
To meet a margin call, you may seek to reduce your risk and/or increase your account’s net equity. This includes:
- Depositing additional funds to cover your deficit
- Depositing additional securities (that have margin loan value) to increase your account value
- Buying to close an uncovered position
- Selling to close an existing long position
As such, placing an order to open a naked or uncovered position is not allowed while in liquidation-only status, as it may increase your exposure to risk.
It’s important to know there are six basic synthetic relationships. Synthetic relationships are those in which two strategies are put together to create a third strategy. Since there are also six basic building blocks in the options world, (i.e., long and short stock, long and short calls, and long and short puts), it makes sense there are six basic synthetic relationships.
- Long synthetic stock—Long call and short put
- Short synthetic stock—Short call and long put
- Long synthetic call—Long stock and long put
- Short synthetic call—Short stock and short put
- Long synthetic put—Short stock and long call
- Short synthetic put—Long stock and short call
It helps to know that for synthetic options, if the call is long (short), then the put is also long (short) in the corresponding synthetic, and vice versa. For example, a long synthetic call contains a long put as one of its components. A short synthetic put contains a short call.
It is also important to note for synthetic stock, whatever you do to the call, you do the same to the stock. For example, long synthetic stock contains a long call, whereas short synthetic stock contains a short call.
Synthetic relationships are those in which two strategies are put together to create a third strategy.
Typically, when an equity option expires, it does so either out of the money, at the money, or in the money. If the option expires at or out of the money, the option has no real value and no time value so it expires worthless. If it expires in the money, the option has real value and will be converted to shares of its respective underlying equity at the strike price. The risk due to the uncertainty surrounding expiring options where strikes are at or near the closing stock price is referred to as “pin risk”.
In practice however, things can differ. Suppose you sell an at-the-money straddle in stock XYZ currently trading for $40 per share. You’d be short the 40-strike call and the 40-strike put. Now, what happens if at the closing bell on expiration day the stock settles at exactly $40 per share? At first glance, it may seem both options would expire worthless, however it’s a bit more involved. It turns out that if you’re short at-the-money options at expiration, there is no guarantee that the options will expire worthless. The person with the long call or put positions may, or may not, decide to exercise their options. In fact, traders have been known to exercise options even when they’re slightly out of the money in order to establish a stock position prior to the opening bell on the following Monday.
As you can see, you really don’t know what can happen on expiration day. This is why it’s important to close out any short options prior to the closing bell on expiration day.
Option pricing model factors
There are standard factors to consider within an option pricing model. Some of these factors include:
- Option type (call or put)
- Option strike
- Stock price
- Interest rate
- Frequency and amount of dividend
- Time to expiration
- Implied volatility level
When you enter these values into an option pricing model, the model will return a theoretical option price. Alternatively, if you enter an existing option price along with values for the first six factors, the model will provide an implied volatility level.
Examples in this article are for hypothetical purposes only and not a recommendation.
E*TRADE from Morgan Stanley portfolio margin requirements
To become a portfolio margin customer at E*TRADE, you must be approved for, and have, options level 4 enabled on your account. By qualifying for options level 4 (our highest skill level), you are able to short uncovered equity call options in your portfolio margin account.
You are also able to hold uncovered short index call and put options. Essentially, at this level you have no limitations on the options strategies you can use in your portfolio.