Regulation T & FINRA margin rules

Deposit requirements represent the money needed to execute an investment strategy in a margin account. Investors are subject to Regulation T and FINRA requirements when borrowing money from their broker-dealer.

Regulation T is a margin-related rule that requires investors to make a specified deposit when borrowing capital (money or stock) for investment purposes. Investors must generally deposit 50% to establish (long or short) stock positions in margin accounts. For example, an investor purchasing $10,000 of stock must deposit a minimum of $5,000 (borrowing the other $5,000).

FINRA requires a margin equity (ownership) level of $2,000 to make use of margin loans. Applicable margin regulations require a deposit of the greater of* their Regulation T and FINRA requirements.

*If an investor establishes a long stock position for less than $2,000, the deposit requirement is 100% of the stock value. For example, assume an investor purchases 100 shares at $12 for a total of $1,200. The investor only must deposit $1,200, as they cannot lose more than this amount. If an investor establishes a short stock position, they must ALWAYS deposit the greater of 50% or $2,000, no matter how small the position. Short stock positions are subject to unlimited loss, so a minimum of $2,000 must always be deposited.

Long options margin rules

Long options contracts generally cannot be margined and require a deposit of 100% of the premium. This rule applies to all options with expirations of nine months or less. LEAPS options with more than nine months to expiration can be purchased on margin, but the investor must deposit 75% of the premium. For example, assume an investor goes long a LEAPS call with three years to expiration at a total premium of $1,000. The investor must deposit $750, with the remaining $250 provided by the broker-dealer as a margin loan.

The same rules discussed above apply when an investor goes long multiple contracts. Long straddles and combinations require the investor to pay 100% of all premiums unless the contracts maintain expirations longer than nine months.

Short options margin rules

Margin rules related to short options contracts vary depending on whether a contract is covered or uncovered (naked). We’ll start initially with covered options contracts.

Short covered options

There typically is no margin requirement* when a short options contract is covered. If the stock position covering the contract is being established simultaneously with the short contract, the option premium reduces the stock’s margin requirements. Let’s explore how this works with covered calls first.

*To be clear, there is no margin requirement for the short covered option, but there will be a margin requirement for the stock if it is being established alongside the option.

As a quick refresher, let’s explore the items that may be used to cover a call:

Long shares
Long call*
Rights or warrants
Convertible securities
Bank guarantee letter**

*For a long call to cover a short call, the long call must maintain the same or lower strike price, plus the expiration must be the same or longer.

**A short call is considered covered if a banking institution provides a guarantee letter stating it will cover the costs related to an assignment.

Let’s explore a practice question:

A customer establishes the following positions on the same day in a margin account:

Long 100 ABC shares at $50
Short 1 ABC Jan 55 call at $3

Assuming no other positions exist in the account, the investor must deposit what minimum amount to establish these new positions?

Can you figure it out?

(spoiler)

Answer = $2,200

The customer’s Regulation T initial deposit requirement for the ABC stock is 50%. The investor purchased $5,000 of ABC shares, so they must deposit $2,500 (50% of $5,000).

The short call has no margin requirement because it is covered. Additionally, the $300 premium reduces the overall amount needed to deposit. Therefore, the customer must deposit $2,200 ($2,500 - $300).

Now, let’s discuss covered puts.

As a quick refresher, let’s explore the items that may be used to cover a put:

Short shares
Long put*
Cash (equal to the maximum loss)
Bank guarantee letter**

*For a long put to cover a short put, the long put must maintain the same or higher strike price, plus the expiration must be the same or longer.

**A short put is considered covered if a banking institution provides a guarantee letter stating it will cover the costs related to an assignment.

Let’s explore a practice question:

A customer establishes the following positions on the same day in a margin account:

Short 100 XYZ shares at $90
Short 1 ABC Jan 85 call at $7

Assuming no other positions exist in the account, the investor must deposit what minimum amount to establish these new positions?

Can you figure it out?

(spoiler)

Answer = $3,800

The customer’s Regulation T initial deposit requirement for the short XYZ stock is 50%. The investor sold short $9,000 of ABC shares, so they must deposit $4,500 (50% of $9,000).

The short call has no margin requirement because it is covered. Additionally, the $700 premium reduces the overall amount needed to deposit. Therefore, the customer must deposit $3,800 ($4,500 - $700).

Sidenote

Regulation T vs. margin call

There is a subtle difference between Regulation T requirements and margin calls (the amount required to be deposited) with covered calls and puts. Let’s first establish this example:

Long 100 ABC shares at $48
Short 1 ABC Jan 50 call at $4

Regulation T states the investor must deposit 50% of the total share value (which is $2,400) and nothing for the short call. Therefore, the investor’s Regulation T requirement would be $2,400.

If a question asked for the margin call (again, the actual amount that must be deposited), it would be $2,000. The $400 call premium reduces the Regulation T requirement.

It’s a subtle difference, but it may be tested. Be careful!

Short naked options

As we discussed previously, short naked options can be extremely risky. Short naked calls are subject to unlimited risk, while short naked puts are subject to significant (but limited) risk. It shouldn’t be a surprise that naked options require funds to be deposited before establishing the position. Generally speaking, those requirements are:

Total option premium
+ 20% of total exercise value*
- Total “out of the money” amount**
= minimum required deposit

*The total exercise value represents the overall value of stock transacted during an assignment. For example, assume an investor is short a 50 call and is assigned. They must purchase 100 shares at $50, so the total exercise value is $5,000 (100 shares x $50).

**If an option is “at” or “in the money,” this part of the equation is excluded.

Let’s explore a few practice questions:

In a margin account, an investor writes 1 BCD Jul 30 call at a premium of $4 when BCD’s market price is $28. Assuming no other positions exist in the account, what is the minimum deposit requirement?

Can you figure it out?

(spoiler)

Answer = $800

This formula must be used to determine the answer:

Total option premium
+ 20% of total exercise value
- Total “out of the money” amount
= Minimum required deposit

The total option premium is $400 ($4 premium x 100 shares per contract). The total exercise value is $3,000 ($30 strike x 100 shares). 20% of the total exercise value is $600. The contract is currently “out of the money” by a total of $200 ($2 OTM x 100 shares).

Now, we can do the calculation:

$400 (total option premium)
+ $600 (20% of total exercise value)
- $200 (total “out of the money” amount)
= $800 minimum required deposit

Let’s try another question:

In a margin account, an investor writes 1 CDE Dec 60 put at a premium of $7 when CDE’s market price is $58. Assuming no other positions exist in the account, what is the minimum deposit requirement?

Can you figure it out?

(spoiler)

Answer = $1,900

This formula must be used to determine the answer:

Total option premium
+ 20% of total exercise value
- Total “out of the money” amount
= Minimum required deposit

The total option premium is $700 ($7 premium x 100 shares per contract). The total exercise value is $6,000 ($60 strike x 100 shares). 20% of the total exercise value is $1,200. The contract is not “out of the money” (the contract is “in the money” by $2), so the last variable will be blank.

Now, we can do the calculation:

$700 (total option premium)
+ $1,200 (20% of total exercise value)
- $0 (total “out of the money” amount)
= $1,900 minimum required deposit

Let’s discuss what happens when an investor establishes multiple naked short legs, which would typically be created through a short straddle or combination. The requirements of both legs must be calculated, and the investor must deposit the higher of the two calculations. The investor must additionally deposit the total premium value of the leg representing the lower of the two calculations.

Your head may be spinning after the last few sentences, but let’s break it down through a practice question:

A customer establishes the following positions on the same day in a margin account:

Short 1 MNO Mar 80 call at $7
Short 1 MNO Mar 80 put at $4

Assuming no other positions exist in the account and MNO’s stock price is currently at $82, the investor must deposit what minimum amount to establish these new positions?

Can you figure it out?

(spoiler)

Answer = $2,700

This formula must be used to determine the answer:

Total option premium
+ 20% of total exercise value
- Total “out of the money” amount
= Minimum required deposit

We have two sides, so we must perform the calculation twice.

Short call calculation
The total option premium is $700 ($7 premium x 100 shares per contract). The total exercise value is $8,000 ($80 strike x 100 shares). 20% of the total exercise value is $1,600. The contract is not “out of the money” (the contract is “in the money” by $2), so the last variable will be blank.

$700 (total option premium)
+ $1,600 (20% of total exercise value)
- $0 (total “out of the money” amount)
= $2,300 minimum required deposit

Short put calculation
The total option premium is $400 ($4 premium x 100 shares per contract). The total exercise value is $8,000 ($80 strike x 100 shares). 20% of the total exercise value is $1,600. The contract is currently “out of the money” by a total of $200 ($2 OTM x 100 shares).

$400 (total option premium)
+ $1,600 (20% of total exercise value)
- $200 (total “out of the money” amount)
= $1,800 minimum required deposit

The short call’s $2,300 requirement is greater than the short put’s $1,800 requirement. Therefore, $2,300 must be deposited plus the short put’s $400 premium, for a total of $2,700.

Spreads

If you understand how call and put spreads work, the margin requirements will be easy to understand. Investors must deposit at least the maximum loss when a spread strategy is established. For example:

A customer goes long 1 AAA Oct 40 call at $8 and goes short 1 AAA Oct 50 call at $3. What is the minimum amount that may be deposited to establish these positions?

Can you figure it out?

(spoiler)

Answer = $500

Using the spread system discussed in a previous chapter, we can determine the maximum loss in step one. The investor has a $500 net debit when the premiums are netted. The net debit represents the maximum loss, which is the minimum required deposit. Therefore, the investor must deposit $500.

Key points

Regulation T

Requires 50% deposit for margin trade

FINRA margin requirement

Minimum equity of $2,000

Long options initial margin requirement

Deposit 100% of the premium

Long straddle initial margin requirement

Deposit 100% of combined premiums

Short covered options initial margin requirement

No margin requirement
Premium reduces cost of stock

Short naked options initial margin requirement

100% premium + 20% exercise value - OTM amount

Short straddle initial margin requirement

Higher of two leg requirement + premium of other leg

Spread initial margin requirement

Deposit the maximum loss