IB - Margin Requirement for butterfly

[narrative 0]

Hi,

 

Thanks for running this excellent learning resource. I'm new to this so I apologise if I have missed something obvious. 

 

I'm trying to open the SPX September 2015 butterfly #2 trade, and I understand that I will be debited the net cost of the contracts of all the legs combined. In Kim's thread he managed to get a $6 fill, which would be $600 after accounting for the x100 multiplier. 

 

However, TWS is telling me I need a margin of 15k+ to maintain this trade, and refuses to let me send the order as I do not have enough cash in my account to maintain the margin.  

 

I saw on IB's website that:

The margin requirement for this position is (Aggregate call option second lowest exercise price - aggregate call option lowest exercise price). Long option cost is subtracted from cash and short option proceeds are applied to cash.

[http://ibkb.interactivebrokers.com/node/603]

 

 

Am I doing anything wrong or is this expected behaviour. Do I need a margin account to make this trade?

 

Thanks all,

Charles

 

 

[Kim 7,513]

This doesn't make sense. You need to contact them and ask. There should be no margin requirement on this trade besides the debit.

[TDM 33]

Hi Charles,

 

You asked at the end if you need a margin account to make this trade. In my experience, you need a margin account for most spreads, because you are simultaneously buying and selling large amounts of options, even though they are executed as spreads. Thus, most brokers require a margin account to execute the trades, even if you are not actually using the margin account to borrow money. Not sure if this relates to your problem; that line at the end caught my eye. 

[narrative 0]

Thanks, Kim. I've gotten in touch with them to see what the issue is.

 

TDM - I didn't open a margin account as I had the impression that they need a $100k account balance, and I am just trying this out with a $10k starting amount. I'm also not sure if it relates to my problem, but thanks for chiming in. I'll see what IB says.

[Kim 7,513]

Margin account needs 10k starting balance. I think it could be related, and I would recommend margin account anyway for some of our other trades (SPY/TLT combo and VIX trades for example will definitely require margin account).

[narrative 0]

Thanks, Kim. 

 

I am reluctant to open a margin account as I am relatively new to options trading and have this (probably unfounded) fear of ending up owing margin to IB and having to liquidate other investments to pay for those losses.

 

I had thought that with a cash account the maximum I would lose is the account balance, and was okay with missing out on some of the trades (VIX for example) until I felt more comfortable and had a better understanding of the strategies..

[Kim 7,513]

If you don't trade VIX and keep your allocation proper as recommended, you cannot lose more than your account value. In fact, since we usually keep around 40% in cash, you cannot lose more than 60% of the account anyway. 

 

Do they let you trade calendars and straddles in cash account?

[TDM 33]

Hi Narrative,

 

I remember when I had that same fear. I was convinced that margin trading was too risky, because of exactly what you said--I didn't want to lose more money than I put in.

 

Ultimately, I realized a couple things. First of all, I needed margin in order to trade most types of spreads. Since they involve buying one option and selling another, it doesn't matter that your risk is defined--your broker requires you to have margin just to execute the trade. It is up to you to know what your risk is. Some spreads--like most calendars--have risk limited to the debit you paid. Others, like SPY/TLT, have risk limited to the difference between the strikes of the spreads. Others, like VIX Calendars, have risk substantially beyond the margin requirement. It's what we call "tail risk"--very unlikely events. But those events do happen, and theoretically your losses are unlimited. (In practice, there is some limit to how high volatility can go, but that limit is not necessarily the margin required, like it is for other spreads).

 

The second thing I realized was that by getting a margin account and trading spreads, I was actually reducing my risk. Although it's counter-intuitive, you stand to lose much much more if you are limited to buying calls and puts (so, directional positions & straddles with substantial time decay) than if you trade spreads, where you can take advantage of more nuanced market conditions and have multiple options hedging your bets. By taking advantage of the "difference" between two options, you're taking on less risk than if you were to buy or sell either option by itself. Of course, you can still take excessive risk through poor position sizing and management, but spreads themselves are not inherently riskier- I think they've got quite a bit less risk when done well.

 

Finally, there's quite a bit of research which shows that implied volatility is, on average, higher than statistical volatility for indexes. This means that option selling strategies, like our Butterflies, Iron Condors, and SPX/RUT Calendars--have a statistical edge. No, they won't be profitable every month, but there is money to be made in the long run by selling options, and you can't do that without margin (except for a few covered calls).

 

I don't intend to push you to open a margin account- I know it's a tough decision, and I wouldn't be writing this if you hadn't expressed that you're prepared to lose all of the cash you put into your trading account. Trading is risky, and it's surprisingly easy to get arrogant and make stupid decisions (I've got a large loss right now in VXX puts to prove it). I just wanted to share my experiences and what helped me make the decision.

 

If you're still uncomfortable, you might talk to IB about coding your account to only trade defined risk spreads, to ensure you don't accidentally place a trade like a VIX calendar with more risk than you're comfortable with. It would essentially be like an IRA, which can trade options, but only so long as all positions have a defined risk and there is sufficient cash to cover that risk. I don't know if they do it, but I do know it's possible because they have to do it for IRAs:

 

http://ibkb.interactivebrokers.com/node/188

 

Hope this helps, and best of luck to you in whatever form of trading you decide to do.

Edited September 1, 2015 by TDM

[narrative 0]

Kim - Thanks for the info. I haven't tried trading a calendar or straddle, but I managed to trade the iron condor okay.

 

TDM - Thanks for the taking the time to write! It's definitely clear and well explained, and you make a very good case. I'll give it some thought but you've pretty much persuaded me to switch to a margin account! I appreciate how you shared about your own arrogant/stupid decision, reminds me to keep some perspective. 

[narrative 0]

Just to update, I've upgraded to a margin account. Still learning and understanding.