- Timing
- Some Notes About the Data
- Working with Minute-by-Minute Data
- Additional Notes Regarding Collateral Requirements and Pattern Day Trading Rules
This chapter is from the book
This chapter is from the book
This chapter is from the book
Additional Notes Regarding Collateral Requirements and Pattern Day Trading Rules
Many of the trades described in these pages are structured as ratios where a certain number of options are purchased at one strike price and a larger number sold at a more distant strike. For example, a call ratio spread consisting of 10 long $95 calls and 20 short $100 calls would be referred to as a 1:2 call ratio. Many of our discussions use a larger ratio—most typically 1:3. Each of these trades has a naked short component because more options are sold than bought. The naked short component has a collateral requirement equal to 100% of the option proceeds plus 20% of the underlying security value minus the amount that the option is out-of-the-money. For $105 strike price calls costing $2.50 on a stock trading at $97, the calculation for a single contract would be as follows:
|
Option proceeds |
100 × $2.50 = |
$250 |
|
Underlying stock |
20% × 100 × $97 = |
1,940 |
|
Out-of-the-money adjustment |
($105 – $97) × 100 = |
(800) |
|
Total |
1,390 |
Because the adjustment for out-of-the-money options can be very large, a minimum of 100% of the option proceeds plus 10% of the underlying security value applies. Throughout the book when profits are mentioned, they are measured against the value of the original position, and collateral requirements are not included. For example, if a trade is long $5,000 of options and short $4,000, then the initial net cost of the trade is just $1,000. If the trade is ultimately closed for $1,500, the gain is considered to be $500 or 50%. Critics will rightfully point out that the return should be calculated using the collateral cost because this money must be present in the account while the trade is open. I have intentionally avoided this comparison because collateral requirements vary between brokers for different customer accounts.1 In addition, for customers who are able to take advantage of portfolio margining, the requirement for a particular trade depends on other positions in the account. It is generally a good idea to understand the collateral requirements for your own account, and to keep these in mind when placing short trades.
One additional requirement to keep in mind is the SEC 2520 Pattern Day Trader rule, which requires day traders to maintain account balances of at least $25,000. In this regard, the term pattern day trader refers to an investor who executes four or more “round-trip” day trades within five business days. The strategies outlined in this book are, therefore, not appropriate for accounts smaller than $25,000 because they involve opening and closing the same position during a single trading session.