Option newbie here. I was talking to my broker ToS regarding what would happen if the short put option was exercised early (yes I know it might be unlikely to happen), but I wanted to make sure I know what happens in the worse case scenario. Most places I've researched on the net and in books say the margin required and max loss is the difference between the strike price minus the credit received. However, after talking with my broker to see what would happen if the short put option was exercised early which would of course force me to buy the stock at the put price, but by having stock and an open long put I'd have a different set of margin requirements per ToS support as I would need enough money to buy the stock. This makes sense I suppose in that the margin requirements would change and I'd need enough money to cover buying the stock when the short put is exercised. However, my question is given that most books and examples on the net say your margin required is only the strike price diff - credit seems a bit misleading. And that's just the initial margin to initiate the trade, but to be fully covered you'd need enough money as if you were to buy the stock. This seems to defeat the purpose of using option and a spread to reduce the cost? I guess if you don't think about being exercised you can leverage your account and trade as many spreads as your account allows but could end up burnt if exercised with a margin call. So if I want to be ultra-conservative with my risk to avoid margin calls I won't be able to take advantage of any leverage with the initial margin required to make the trade. Am I missing something? Thanks in advance for any insight as I've been racking my brain all day about this.
Theoretically you are correct, as far as I know. In real life, not a situation you're likely to come up against. Even on expiration day, and recently I had the experience of trading some options on that day, the option is priced so as to make exercising it by the buyer too expensive to be worth it, at least in the morning. By afternoon, you might run into a weird problem, but really unless you're the buyer and are actually intending to exercise the thing, if you have an ITM option on expiration day, you should exit it before afternoon. In other words, if you're the seller and you don't want to be exercised, get out before the clock strikes noon on the day of expiration, if you find yourself still in one you've sold at the open of trading on that day. TOS allows you to buy back a sold option who's price is 5 or lower commission free. Take liberal advantage to prevent this happening to you.
If you want to limit your expenditure, shall we say, to the spread, then you will need to use European options. RUT for example.
If the short put is exercised early then you would need to meet the margin requirement on holding the long stock, assuming you would actually want to continue to hold it. If you close out your position right after the exercise then you don't really need the full amount. That is, you get assigned and you don't have enough funds in the account, you get a margin call, you close out the stock position and the problem is solved.
Option margin is approx 20%. Equity margin is approx 50%. So if assigned early, you either need to pony up the extra margin in order to carry the position or you'll have to close the equity position if your broker doesn't automatically do the latter immediately. Options are not likely to be exercised if there is time premium remaining but that doesn't mean it can't happen. I once had some naked otm MSO calls exercised 2 weeks before expiry and they were worth nearly 2 pts. Also, be careful of the advice you get from brokers. Sometimes they don't get the deatails right. Complexities are often better understood by more knowledgeable people in the margin or compliance dept.
Thanks a lot for the info guys! Didn't know about the European options, and using indexes instead to avoid early assignment. Also thxs for the tip on just closing out the stock position right after the assignment to cover the call.