Day8.Why does the option seller require margin while the buyer doesn't?

Hello

Welcome to Tiger Academy - 「Options Academy Column」 Issue 8.

In the previous session, we discussed how to speculate on financial reports using options.

We concluded that being a seller carries lower risk and higher win rate but lower returns, while being a buyer entails higher risk, lower win rate, but higher returns. Now, the question arises: since buyers and sellers are counterparties, why are the seller's returns so low?

The reason is simple. As we previously mentioned, the seller of an option is the obligated party. If market conditions are unfavorable, the buyer may choose not to exercise the option, limiting the seller's maximum profit to the premium received. Additionally, because the seller needs to provide margin, unlike the buyer, their return on investment is significantly diluted due to the margin requirement. For instance, if the option price increases by $10, as a buyer with a $100 investment, the return would be 10%. However, if the seller's investment is $1000, the return in this case would only be 1%.

Now, the question arises: Why do option sellers need to provide margin while buyers do not?

1. Why Sellers Need Margin

Let's illustrate with an example: Suppose A is the buyer of an option and B is the seller. They enter into a call option transaction. A pays a premium of $10 to buy a call option for Tesla with a strike price of $100.

B receives an initial premium of $10. Assuming the Tesla stock price is also $100, the call option is at-the-money.

If B, as the initial seller, doesn't provide margin, and if the stock price rises, A starts to profit while B incurs an equivalent loss. If the stock price rises above $110, B's received premium of $10 is wiped out. At this point, B faces the risk of default. If, by the expiration date, the stock price rises to $120, as the obligated party, B has to buy the stock for $120 and sell it to A at $100, incurring a loss of $20. Deducting the earned premium of $10, the net loss is $10.

Thus, in such a situation, without margin, B would likely choose to default.

As for A, the buyer, no margin is required. If the stock price falls, and on the expiration date, it's below $100, A can choose not to exercise, limiting the maximum loss to the $10 premium already paid when buying the option.

In essence, the fundamental reason is that the option buyer holds the right to exercise or not, making them the one with the power. They don't need margin. Conversely, the seller has the obligation to fulfill the contract if the buyer exercises. With the potential for unlimited losses upon exercise, the seller needs margin.

2. How Much Capital Do Both Parties Need to Use?

When a options contract trade is successful, how much capital do both the buyer and the seller need to utilize? Let's consider an example using an at-the-money call option for Starbucks that expires on August 4th. If you're the buyer and wish to execute immediately, you would need to buy at the asking price of $0.83. Calculated for 1 contract representing 100 shares, this would require $83.

For the seller, the situation is a bit more complex due to the requirement for providing margin. If we intend to sell that option, the option contract's price, the underlying asset's price, and the strike price will all affect the amount of margin needed. Keeping other conditions constant, as the option price and the underlying asset price increase, the required margin also increases. The margin for out-of-the-money options is smaller than for in-the-money options. In simple terms, the more out-of-the-money the option is, the lower the margin requirement.

Using the same example of the at-the-money call option for Starbucks expiring on August 4th, if you're the seller, the required margin would be $2,639. This is significantly higher than the $83 capital requirement for the buyer.

If the market value of the option increases by a hundred dollars, the buyer's return rate is around 120% (100/83), whereas the seller's return rate is merely 3.78% (100/2639).

Alright, that concludes our discussion on option margins. For those interested in option investments, there's a free introductory course available for you to learn.

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See you in the next episode!~