Cash or margin: what the trade actually ties up

The number nobody quotes

Ask someone what they made on an option trade and they will tell you the payment they collected. Forty-two dollars, ninety dollars, two hundred. It is the wrong number on its own, and it is the only one anybody says out loud.

Collecting $90 is excellent if you froze $900 to do it and unremarkable if you froze $9,000. The payment is half a fraction. The other half — what the trade locks up, for how long, and whether that amount can change while you wait — is what this lesson is about, and it is the half that decides whether you were running a business or taking a flutter.

Two ways to back the same promise

Suppose you agree to buy 100 shares of a company at $45 each if they fall that far by a date six weeks out, and you are paid $90 up front for agreeing. That promise is worth $4,500 if it is ever called upon.

Your broker will let you stand behind it in one of two ways. Which one you are using is a setting on your account, and a great many people discover which one they picked only when it matters.

Look at the right-hand bar of each pair in that figure. They are the same height, and they are the point. Margin does not reduce the risk by a cent; it reduces the deposit. The $90 payment measured against $900 looks like five times the return it looks like against $4,500, and the trade underneath is the identical trade.

Leverage does not make a trade better. It makes the same trade louder.

What “margin requirement” actually means

The phrase sounds like a fee and is often mistaken for a loan. It is neither. A margin requirement is a deposit the broker holds against a promise you have made, sized by their estimate of how badly the promise could go. You have not borrowed anything yet. If the promise is never called upon, no money is ever lent and the deposit is released.

The crucial property — the one that makes margin a genuinely different animal rather than a cheaper version of the same thing — is that the requirement is not fixed at the start. It is recomputed from current prices, typically at least once a day. Three things push it up:

• The stock moves against you. As the share price falls toward the price you agreed to pay, the promise gets more likely to be called upon, so the deposit behind it grows.
• The market gets jumpier. Requirements are built on how far prices might move. When the whole market starts moving further each day, deposits rise on positions whose own stock has done nothing at all.
• The deadline gets closer while you are near your price. A promise that could go either way with two days left is a far less settled thing than the same promise with two months left.

A margin call, in slow motion

Margin calls are usually described as a single dramatic event. In practice they are the last step of something that started quietly a fortnight earlier, and the quiet part is the part worth understanding.

Three things are happening in that figure, and only the third has a name most people know.

• Day 0. You set aside $900 and have $2,000 of spare cash besides. Everything is comfortable.
• Day 12. The shares have slipped 9%. The requirement is now $1,600. The extra $700 comes out of your spare cash automatically. Nobody rings. You may not notice, and nothing is wrong yet — but your spare cash is now $1,300 and your capacity to absorb the next move has quietly halved.
• Day 18. The shares slip again. The requirement is $2,900, and that does not fit. Now it has a name. The broker asks you to fund the gap, usually within a day or two, and if you cannot or do not, they close the position themselves.

This is the whole case against leverage for someone new, and it has nothing to do with greed or discipline. Margin converts a position you could have held into a position you might not be allowed to hold. Those are different trades.

Why this app shows you the cash number

On every result screen, the figure labelled Cash or shares tied up is the full cash-secured amount: the agreed price times 100 for a put, the market value of your shares for a covered call. Every return percentage in this app is calculated against that figure.

That makes the headline returns look smaller than the same trades look on plenty of other screens, and the reason is deliberate. A return calculated against a deposit is a return calculated against a number that can be raised without your consent while the trade is open. It is arithmetically fine and practically misleading: it tells you what you earned on the money you happened to have posted on day one, not on the money the position can demand of you by day eighteen.

Assignment: the day the promise becomes a trade

The other thing that ties up capital is the obligation being used. Assignment sounds like a penalty and is not one — it is the deal you were paid for, happening.

If you sold a put at $45 and the shares finish below it, your frozen $4,500 becomes 100 shares. You now own a company at $45, having been paid $90 for the privilege, and your effective price is $44.10. Whether that is good news depends entirely on whether you wanted to own it — which is why the only strikes worth selling are prices you would be content to pay.

Two practical notes that catch people out, and neither is in the headline numbers:

• It can happen before the deadline. On individual company shares, the other side may exercise early. It is uncommon unless the contract is deep in the money or a dividend is about to be paid, but “by the deadline” is the accurate phrasing, not “on” it.
• On margin, assignment is when the loan appears. Up to that moment nothing was borrowed. The instant the shares arrive and your deposit was $900 rather than $4,500, the difference is a real debit balance accruing real interest — and the position that was a short put is now a leveraged stock holding, with its own requirement.

Three questions before any trade

None of these need a calculator, and answering them takes about twenty seconds once it is a habit.

Where to go next

You now know what the capital figure on every screen means and what it deliberately leaves out. The next lesson takes on the other number that dominates those screens — the percentage — and where it actually comes from. After that comes why a high percentage is not the same as a good trade.

If a word on any screen stops you, it has a definition: the glossary defines every term the app uses, including these ones, written for someone who has never traded an option.