How much it costs to place a trade is known as the margin requirement or the buying power reduction. This is what your brokerage firm considers your risk for a given trade. This will change based on the brokerage firm but is generally calculated in a similar fashion.
Today, Tom Sosnoff and Tony Battista discuss all of the different ways that Buying Power can be calculated. Next, the guys look at when and why the buying power of a naked option will change. This is due to the movement of the underlying and the risk that is associated with those moves. Finally, the guys look at you are able to use buying power more efficiently by defining your risk!
Tony: Thomas, we're back my friend. Best Practices, we're talking about buying power reduction. Tom: I was going to give away the Tony Robbin's book today, but somebody... Tony: You said that they were the Cherry Bomb actually. Tom: Yeah. Somebody, the first person to email me said, "Tom, I will." Tony: Take you up on that offer? Tom: Yeah. I want to make you the following proposal. I'll give you $30 for your copy of the Tony Robbin's book, signed of course, that says, "This sucks. Tom Sosnoff." Eric, I am going to send you. I don't want your $30. I am going to send you, you send me your address, and I will send you that signed copy (laughs) Tony: Slightly used signed copy. Tom: Slightly used signed copy, and I'll be happy to send this to you. I want it out of my possession, because I don't ever want to end up in a box that I move someday. I have to load this book with me, one place or another, so thank you. You get it. Tony: Awesome. I like that. Tom: Yeah. No problem. I did create a little, a fun
Tom: I created a fun little giveaway for this book today, but do you want to do it to start the week off? Tony: Is this your, is this your? Tom: Are you ready? Tony: Is this what you were working on yesterday? Tom: Yeah, it's a fun thing. Linda, do you have that tasty game thing I sent you? Tony: You're beautiful. Tom: Okay. Hold on. Tony: How do you, but you just said you were going to give the book away. Tom: Yeah, I'm going to give away another thing. We got a really cool Tony: Why give away? Tom: I got something cool. I got a brand new dough hat. Hey, Beth, ask Linda if we have an extra dough hat. Tony: Of course we do. Tom: Oh yeah we do? Tony: Sure. Tom: All right. Ask her if we could bring it in. I want to give away Tony: No. Tom: What? Tony: Okay. Maybe. Just bring it in. Got it. Tom: Yeah. Okay. Are you ready for this quiz Linda? Each page is one Tony: Will you model it for everybody? Tom: No, I will not. Tony: Come on. Tom: No. But I want to do this. Because, I put together this, we'll get this segment in 1 second. But who out there has, thinks they have a unique knowledge of tastytrade history? You're gonna have to have been watching the show for at least 3 years. If you haven't watched the show Tony: This has nothing to do with finance, trading, Tom: Nothing to do with finance Tony: Or anything else like that, but if you've been watching the show you should know the answer to these questions. Tom: If you think you have a unique. No, you should not. This is not easy. Tony: Well Tom: But if you think you have a unique understanding of tastytrade history, and you've been watching the show for at least 3 years, call in. What's the number, Tony? Tony: 855-238-2789 or 855-BE-TASTY. Tom: It will only take about a minute. Oh beautiful. Tony: It's the number on the right-hand side of the screen if you are not familiar with that. Tom: Oh, it's the lovely Katie. Tony: Thank you Katie for bringing that in. Tom: Smile. Look at this. Brand new. This is for the winter storm, Tony. Tony: It won't get there in time for the Tom: Here you go. It's beautiful. Tony: Put it on the mic so nobody can hear you. That's good. I'm the trustee. Tom: Here you go. Tony: No, no, no. Keep it over the mic. I prefer it that way. Tom: Okay. Tony: Who has a unique 3 years, at least 3 years of tastytrade viewing, listening Tom: Knowledge? Tony: Knowledge. Tom: Who thinks they can answer a trivia question. Tony: See now, if I knew you were going to do this, we could have promoted it and you could have people waiting online. Tom: No, no, no. I need to test this first on the fly. Tony: Lines are wide. Give it a minute. Tom: Okay. Tony: 855-238-2789 or 855-BE-TASTY. Numbers on the right-hand side of the screen. If you get a busy signal just means the lines are busy, but they will drop and open up again, so give us a call. Because I don't think the first few people are gonna be able to get this. Tom: Don't you worry okay? Tony: Got to go to California. I got Ramond. Raymond in California, you'll be up first. Tom: Hey, Ray. How are ya? Caller 1: Good morning. Tom: How are ya? Caller 1: Good. Tom: How long have you been watching tastytrade? Caller 1: About 3 years. Tom: Awesome. You think you have a decent understanding of our history, right? Caller 1: I believe so. Tom: I got a beautiful, we just got these. We just got these from Tony's mom hand saw sawed these with the dough in front. Caller 1: Nice. Tom: They're awesome. You think you can answer some trivia questions? Caller 1: I hope so. Tom: I am going to ask you 5. Linda, how many are on there? 5 trivia questions? 6. How about this, all you have to do is get 2 right. Caller 1: Okay. I'm up for it. Tom: All you have to do is get 2 right. This is Tony: Ramon? Tom: This is Ramon? No, who is this? Caller 1: Yes. Tom: Ramon Tony: Ramon Tom: All right Ramon. You ready? You only have to get 2 right. Tony: 2 Caller 1: Okay Tom: All right. Let's do it. Linda? Tony: What kind of car did Tony drive to Chicago in 1980? Caller 1: (laughs) Tom: See, these are not easy. Caller 1: A pinto. Tony: A pinto (laughs) Tom: No. Tony: My name is not Antonio (laughs). It's Anthony. Tom: All for one. Caller 1: Yes. Tom: What is Vonetta's dog's name? Caller 1: Oh Tony: She talks about this mutt everyday. Come on Ramone. I'm pulling for you. Tom: It's a pure bred mutt. Caller 1: Oh I do not know. I could guess. Kai? Tom: No. Tony: Do you want to go to more questions? Do you want to wait and get to the next caller. Tom: No. There's going to be only one caller today. Tony: Okay. Tom: Only one caller. I'm sorry Linda. I should've thought. Tony: You just got to get 2 out of the 6? Tom: You just got to get 2 out of the 6. Tony: Oh, easy for you man. Caller 1: Not looking good. Tom: Vonetta's dog's name Caller 1: All the way up to March, but mainly, mainly your show. I think I skipped, cause I'm I probably watched Tom: I don't care what you've done. This is a competition. We don't want to know your history. (laughs). Vonetta's dog's name is Calida. Tony, what was your car in 1980? Tony: Dodge Diplomat Tom: Dodge Diplomat. All right? You still can win this. You only got to get 2 right. Let's go to the next one, the third one. In what year did Tony get engaged for the first time? Caller 1: (laughs) For the first time? Oh shoot. Tony: Don't worry man. Tom: Think a young Tony Battista/like John Travolta type character. Tony: What did you just say Raymon, because I just want to come to the mic Tom: Good. Caller 1: 1978 Tom: Close. Close. No. I believe it was '81? Tony: Yeah. Tom: Yes. Okay. All right hi, here's a no. You look old here, you have old face. Let's go to the next one. Tony: (laughs) I was 16. Tom: You still can do this. From what resort did Jules order the whole left side of the menu? Caller 1: (laughs) What resort? The Mariott. Tom: No. Caesar's Palace. Tony: Oh 2, Ramone you've got some more watching to do. Tom: You've got 2 left. All right? I said these are hard. What's Linda's favorite food? Caller 1: Beer Tom: That's her second favorite food. That would be fried chicken, first of all. Caller 1: Fried chicken. Tom: All right. Is this the last one Linda? Tony: Yeah. Tom: I'm gonna still give you the hat if you could tell me what Jenny's husband's name is. Caller 1: (laughs) Matthew. Tom: You are oh for 6 Ramon. It's Keith. Caller 1: Yes. Tom: I didn't say this is gonna be easy, okay. Caller 1: Okay. Tom: You're oh for 6. But send us your home address and we'll send you one anyway, okay? I just wanted to play and have some fun. Caller 1: It's so fun watching you guys. Tom: Thanks, man. Caller 1: All right. Tom: I'm sorry for the other person that called in, I should have said we're only going to take one person today. All right. Let's get right into this. Linda, I'm not even going to take a break okay. All right. Let's do Best Practices. Tony: Okay. Tom: That was fun, right? Tony: Absolutely. Tom: It was a little too hard. Tony: It was good. Tom: It was hard. Tony: Yes. It was hard, but Tom: It was hard, Tony: Yes, it was hard, but he was fair about it. Tom: He was a very good sport, but it was very hard. I didn't say I was gonna. Listen, nothing should be easy, okay? I was doing things like, is Tony a... Tony: Stop yourself. Stop yourself. Tom: 616. It is Monday, January 20. Can you believe that someone's seeing this in January? Where has this gone? Buying power reduction. Tony: [inaudible 00:07:54] in February. Think about it. Tom: Next weekend. Tony: Yeah, I know. Tom: Unbelievable. Buying power reduction. A lot of people email us all the time, they have all this crazy questions about buying. Not crazy, they're legit questions, about buying power and buying power reduction. Just to put things in perspective, up until about, this is our 30 something year in the business, but up until we built thinkorswim I don't think we even understand what buying power was, because I had never even heard the term before on the professional side. It's a little bit different. It changes. The terms buying power and buying power reduction are things that we made. We popularized through TOS. They used to be called things like margin and capital required, and I think the buying power reduction makes the most sense. We use the acronym BPR in here, just so that, really to simplify it. Your buying power is your total available capital to place trades in your account. That's it. It's just your buying power. The way TOS list it is your option buying power, because that's similar to your cash. Your stock buying power is 2X. You always have twice as much stock buying power as you have option and future buying power. Just think of it that way. Your total margin Tony: You need so much more buying power to buy the stock. Tom: Yeah, your total account margin-wise is 2X of whatever your option buying power is. Buying power is the initial capital required to make a trade, otherwise it's known as the margin requirements. Now margin requirements do change, they can be reduced, but what they call maintenance margin and everything else, and intraday margin. But just for the purposes of making this really simple, if you have an account and your account has $1 in it, you can use $1 to trade options with. You can use $1 to trade futures with, and you can use $2 to trade stocks with. Okay. That's it. Tony: You broke it down nicely. Tom: How is buying power reduction calculated when I place a defined risk trade? The buying power reduction for a defined risk trade is simply the max loss of the spread. Essentially, what they refuse to call for regular trade purposes, but what you can assume in 99% of the cases now, is the buying power reduction for defined risk is the inverse of your max risk and whatever you collect for doing the trade. Or pay to do the trade. It's essentially called risk-based margin. How much risk do you have? That's how much money you have to put up. If a 2-point wide spread is sold for 66 cents then the max loss and the Tony: Is that inverse of the spread? Tom: Correct. For 1 $0.66 is $1.34. It's just the inverse of $66 - $200 then becomes $134. Tony: Right. Tom: Again, we call it risk-based and that's the easiest way to understand it. That's for defined risk. But how is buying power calculated for undefined risk trade such as a naked put? Well, the buying power required in a standard margin account for selling a naked put is the largest, because it's always, the default is always the greater of. Here are, this is from, these are the direct regulatory requirement. These are the final requirements. 20% stock price minus the out-of-the-money account plus the credit, and then you can figure out. The system obviously does that for you. It takes the greater of, and the reason it takes the greater of is because sometimes you would take for example, you can have a $10 stock. The requirements to a $10 stock maybe so minimal that it's less than reasonable. That's why it's the greater of. Most of these, the first one comes into place. For most of the stocks you trade 20% of the stock price minus the out-of-the-money account, but minus out-of-the-money amount. Sometimes when you trade really inexpensive stocks and you're trying to sell premium in there, puts or calls, you have undefined risk. They will use a different formula because they just want to protect themselves. I think the minimal amount has to be collected has to be $150 or something like that, which makes sense if you think about it. Here's an example for Twitter. It's trading for $39, if sell one 33 put for $1.08 and then they just have the calculations up there in each case. Because Twitters are relatively again, a little bit lower-priced stock they pull the, you can see how the numbers vary dramatically. In this case it's 10% times 33 blah, blah, blah. It picks the highest, the greater of. This is not for portfolio margin either. This is just for regular margin accounts. How is the buying power reduction calculated for a naked call? Well, it's much like the buying power for a naked put. It's the largest of 3 formulas. 2 of the formulas are the same, but 1 slightly different. And they were put up here. There's a difference between the 2. Just because, if you ever wanted this information you can store it in your back pocket and it's there for you. Take a look whenever. Question. Will buying power be constant for the life of the trade? On a defined risk trade the margin requirement will not change, which is why at some point, the reason that we managed winners is because you're not just managing winners, you are also managing your capital that you've committed to the trade. However, undefined risk margin will typically change with moves in the underlying. Let's show you this example. Tom: Here's an example with RIG trading at $16.15. If we sell the 15 put for the $1.28 the table below shows the current margin, and then the margin if RIG moved away from our put strike. You can see that right here the Tony: It's always changing, which is why you have to keep some money on the sidelines, right? I mean Tom: Right. Tony: Okay. Tom: We're just taking a look. At 16.15 the margin is 260, but if it goes down to 15 it's greater, if it goes down on the 14 it's greater, if it goes up to 17 it's greater. It moves around. Tony: Okay. Tom: Now we determined return on capital. All we know is where the stock is when you make the trade. Tony: Of course. Of course. Tom: That's all we know. How can we use buying power more effectively? How can we use buying power more effectively? What is the trade-off? Well, we can often increase the efficiency of our buying power by bringing the strikes closer together, closer to the current price. The trade-off usually manifests itself as a reduced probability of profit. Of course, the greater the capital required to make a trade, the higher the probability of profit is because you're increasing the risk. When you increase risk, you increase the probability of profit. When you decrease risk, decrease capital, you decrease the... Let me try to say it the right way. Tony: (laughs) Do it, do it again. Tom: Yeah. When you increase your risk. Okay I'll say this the right way. You increase the capital required, and you also increase your probability of profit. When you decrease your risk, you decrease your probability of profit because you're making the strikes become contracted. The relationship is almost. There is almost a perfect relationship between probability of profit and capital required. The more capital required, the higher, the greater the probability of profit. The less capital required, it reduces your probability of profit. Tony: Sure, because you're looking at a defined Tom: Yeah, you take less risks, you deserve to make less money. You take more risks, you deserve to make more money. That's, it's hard to understand, and it's actually a perfect model. Here's buying power reduction we used. We used an example. And in XOP, and the other thing about this is... Tony, we are going to cover this in detail today in our Market Measure. It's a really interesting market measure coming up in about 21 minutes. The Market Measure talks about the efficiency of capital versus strikes. Tony: It's called optimizing spreads. Tom: Okay. Here's a perfect example in XOP. A short of 40 put, a short of 35 put, and short the 43, 41 put spread. We showed all the credits received. We show the delta. We show the probability of a profit. The buying power reduction, and the buying power per $1. As you can see middle strike, which has a 92% probability of a profit you have the highest buying power per $1 of premium. It's not the highest buying power reduction, but it's the highest buying power per $1 of premium because we compared apples to apples. And below, with the short spread, you have the smallest amount of risk and the smallest amount of buying power reduction. You also have the lowest probability of profit. Tony: Which makes sense to what you just said, two slides ago. Tom: Yeah, you reduce... Your probability of profit goes down as you reduce your buying power per $1 of premium. That's what spreads do for you. The same thing to a certain affect if you go and you collect more credit. If you collect more credit, you can have, in this case, a lower probability of profit. Your buying power per $1 of premium was middle compared to the other 2. It's a really interesting study that we're gonna show you in just like I said, in 20 minutes. I'm not sure anybody has done it before, but effectively it talks about buying power per $1 of premium. It shows you at some point, where the crossover is, between whether you should widen the strikes, go naked on the position, or stop widening the strikes. Because at some point it doesn't make any sense. Tony: Agreed. Tom: At some point you may be paying more Tony: To make sure on return. Tom: To make sure on return. You may be paying more to do a spread than you would be to do a naked option. That's something that I don't think anybody has ever shown anybody else before. It's really cool. We'll show you that in just a few minutes. Tony: What about buying power on a single option? Will that ever change? Of course, that'll change too. Tom: Yeah, sure. We did that before. You've given an example on that, on a naked put and a naked call. Tony: We'll take a quick break, we'll come back. We got the opening bell in about 4 minutes. This is tastytrade live.