Can Options Trading Put You Into Debt? (Interesting Answer)
If you’re new to trading, you might be wondering if options trading can put you into debt.
In a word: yes.
However, it doesn’t have to. You can also trade with no debt.
The choice is up to you.
In this guide, I’ll explain how trading options can put you into debt and what you need to avoid it.
Let’s get into it!
Go Long and Stay Debt-Free
The first thing you should know about trading options is that if you only open long positions, you won’t have to worry about debt.
For example, if you buy a call option or a put option with cash, you’re using no debt at all. You’re also under no risk of losing more than the amount you invested.
That’s assuming, of course, that you didn’t borrow money you used to place the trade. It’s typically not a good idea to do that, though.
Why? Because the amount of interest you’ll pay on the loan will eat into your return.
Think about it. Let’s say you borrow $100,000 at 7% to trade stocks and options. After one year of trading, your total return on your account is 11%.
Unfortunately, it’s not really 11%. You have to subtract the 7% in interest payments on that $100,000.
That leaves you with a much smaller return of just 4%.
Bottom line: go long on options only with cash and you’ll stay out of debt.
Go Naked and Get in Trouble
You can still get into trouble with options even if you don’t intend to borrow money. That happens when you sell an option and it’s a losing trade.
It’s often the case in options trading that you’ll sell call options against shares of stock that you own or put options against a short sale.
However, your trading platform might allow you to sell “naked” options. Those are options that you sell when you hold no position in the underlying shares.
For example, if you sell a put option contract in IBM right now and you don’t have a short position in IBM, that’s called a “naked put.”
Naked puts can get you into trouble because if you place a losing trade, you have to buy the shares. There are two ways that you can buy those shares:
- With cash
- With borrowed money
If you’re trading with a Level 1 options account, your online brokerage will require you to have enough cash on hand to cover the cost of the purchase. It’s called selling a naked put on a cash-secured basis.
If you’re trading with a Level 3 options account, your online brokerage will allow you use your margin account to purchase the shares.
A margin account allows you to borrow money from your broker to purchase securities. The securities you purchase act as collateral for the loan.
And yes, even though you’re putting up collateral, your brokerage will still charge an interest rate. Contact your broker to get the interest rate for your account.
Back to the naked put: it’s that Level 3 options account that can get you into debt. If you place a bad trade and need to buy the shares, you might have to borrow money.
In that case, you’ll pay interest as long as any portion of the loan is outstanding.
Read Also: What’s A Naked Call?
Reduce Risk (and Return) With Spreads
If you’d really like to sell options but want to reduce your risk of going into debt, all is not lost. You can use spreads.
What are spreads? They’re multi-leg options orders that give you some protection if the trade turns south.
Unfortunately, they also limit your return.
Let’s say you stumble across a stock that you think is going to pop in the near future. You’d like to buy a call option, but you’re concerned that implied volatility and time decay might work against you.
You decide to sell a put option instead. However, you don’t want to be on the hook for buying the underlying shares of stock just in case you’re wrong.
So what do you do? You buy another put option on the same expiration date but with a lower strike price. That’s called a bull put spread.
Now, let’s say your trade goes horribly wrong and the stock tanks. Your long put option will increase in value. That will offset some of the losses from your short position.
Not all of your losses, though. You’ll still take a hit.
But you won’t take as much of a hit as you would have if you had just sold the put option.
Your online brokerage understands that and reduces the margin requirement for the trade. Significantly.
By the way, spreads aren’t the only options strategies that reduce your exposure to margin. Here are a few others:
- Iron butterflies
- Iron condors
Understanding Margin Requirements to a “T”
What are the margin requirements when it comes to trading options? To answer that question, you’ll have to consult Regulation T.
Regulation T dictates margin requirements for brokerage accounts. Companies can get into trouble if they don’t follow it.
When it comes to buying options (i.e., holding a long position), you’re required to deposit 100% of the option premium within two days of settlement.
Effectively, that means you can’t go long on options with margin. That’s a good thing, though, because you shouldn’t go long on options with borrowed money (see above).
The exception to that rule is if you buy a LEAP (or long-term option) that expires in more than nine months. In that case, you only need to deposit 75% of the option’s premium.
If you sell a call option and you’re already long on the underlying stock, you’re covered. You don’t need to worry about regulations in that case.
The same holds true if you’re short a stock and sell a put option against it. Just keep in mind that when you short stocks you’re borrowing money from your broker.
When it comes to spreads, strangles, straddles, and other options strategies, you should consult your online brokerage for margin requirements.
Even though Regulation T dictates minimum requirements, some brokerages add their own rules. Those rules vary from brokerage to brokerage.