What Is Options Buying Power?
Feb 21, 2017
Buying power comes up in many options trading conversations, but what is it exactly and why is it important?
Buying power (sometimes referred to as ‘excess equity’) as it relates to trading stocks and options, is the maximum amount of capital (money) available to make trades with.
As you fund your brokerage account and use your capital to place trades, your available buying power will change.
Buying power reduction refers to the amount of capital required to place trades and maintain them. Or phrased a different way, the amount of capital that will be tied up when purchasing stock or trading options.
Buying power reduction is hard to quantify as a whole because it really depends on the factors like the product being traded (i.e. stocks, options, future, etc.), the type of trade (defined risk v. undefined risk), and the type of brokerage account (margin, portfolio margin, IRA, etc.).
Here is a little more information about buying power as it relates to the type of brokerage account (it’s important to note that each brokerage has their own policies in regards to buying power on certain types of accounts – the below information will help you understand the differences between the account types, but the exact values may vary slightly from brokerage firm to brokerage firm).
In traditional IRA & Cash accounts, your stock and option buying power will be the same number. This is because there is no margin or leverage in an IRA or cash account when it comes to buying stocks. In this type of account, your gains and losses are 1:1, as your trades are all for cash value. For example, if you buy 100 shares of a $50 dollar stock, your buying power reduction will be the full amount; $5000.
In traditional IRA accounts, your stock and option buying power will be the same number. This is because there is no margin or leverage in an IRA account when it comes to buying stocks. In this type of account, your gains and losses are 1:1, as your trades are all for cash value. You can never lose more than the cash value of your account.
In a standard margin account, you have 2:1 leverage when you buy stock and sell stock. This means that if you buy 100 shares of stock, your buying power will only be reduced by half of the notional value: 50 shares of stock. In an IRA account, buying power reduction of all 100 shares would be required. Margin essentially allows you to double your profits or double your losses, less commission fees and interest on the margin you borrow.
Portfolio margin takes your account one step further, and gives you about a 6:1 leverage for stocks. The calculation for buying power reduction is also a little different, as it bases the requirement around the largest projected loss for the day on all your positions. Volatility also plays into this calculation.
The minimum entry equity is $125,000 to obtain portfolio margin, and a net liquidity of $100k is required at all times. Portfolio margin can be revoked at any time.
...that leverage allows you to magnify your gains, but it also magnifies your losses. It is very important to understand the mechanics of buying power reduction, and how it can affect your overall trading experience.
Calculating buying power isn't very difficult, but it can be different depending on what type of brokerage account you have.
Selling naked options in a margin account is a very popular strategy for options traders. Why? There is quite a bit of leverage using stock options in terms of buying power reduction. Because selling a naked option has higher risk than putting on a defined risk trade, buying power reduction is reduced based on the greatest of the following three formulas:
Consider the following scenarios for this trade:
More often than not, option number one will be used because this number will generate the highest value. Higher buying power reductions give the broker more protection on the risk that they are taking with naked options, which is why they use the higher value.
So what about buying power reduction when you buy naked options? The buying power reduction when you purchase a naked option is equal the debit paid for the trade (there are no fancy formulas necessary to calculate this number).
Defined risk trades are also very simple in terms of buying power reduction calculations. Just like buying naked options, buying a debit spread requires a BPR of what you pay for the spread. Buying spreads will always cost less than buying the same long option because we are really just buying the naked option and reducing our cost basis by selling an option against it (commence AHA! moment).
Defined risk credit spreads have a different BPR calculation. For credit spreads, you will have to take the width of the spread and subtract the credit received to see what your BPR will be. For example, if we sell a 5-point wide (110/105) put spread and receive $0.50 in credit for it, our buying power reduction would be $450. (500-0.50 = 450).
Here is a tastytrade segment that covers the topic of buying power reduction and how it relates to trading strategy based on studies that they have done.
Buying Power reduction can be tricky, but it is very important to understand how it works so you can optimize your trading experience and avoid those pesky margin calls!
Have more questions about buying power? Leave a note in the comments section!
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
Sep 7, 2017
Most investors are familiar with what earnings are, but less know about the different strategies and considerations when investing in a company with upcoming earnings. In this post you will learn about what earnings are, the terminology associated with earnings, and how you can place an 'earnings trade.'
Aug 30, 2017
Instead of going through different positions and strategies to figure out which way you need the market to go to make money, delta will give you a snapshot of this information for each position, strategy, and even your overall portfolio. On the simplest level, delta (positive or negative) tells us which way we want the underlying to go to make money.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.