One important aspect of evaluating a trade is deciding how much capital to allocate to it. It’s the absolute amount of dollars and cents required to deploy a particular trade, and which you need in your trading account. We call it buying power reduction (BPR). The minimum BPR for a trade is determined by rules set by FINRA. Brokerage firms can set a higher BPR for a trade, but not lower than the FINRA minimum. Generally, the more risk a trade has, the higher its BPR. A recent episode of Best Practices took up this exact topic and touched on some important points relating to capital that every trader should be aware of when trading equity options.
Traders need to be keenly aware of this value because they don't want to allocate too much capital (i.e. risk) on any one position. Knowing how much capital is needed to establish a trade allows traders to scale appropriately - one of bedrock principles of the tastytrade philosophy.
When selling a defined-risk vertical spread, the most a trader can lose is the width of the spread minus the credit received multiplied by the number of contracts traded and the option multiplier (100 shares/contract). This is also the calculation for Buying Power Reduction (BPR) in the account by your brokerage firm. Here’s an example:
The last sentence on the slide above also addresses the BPR for a long vertical call spread, where the most a trader can lose is the debit paid. In this example, the BPR and amount at risk for a trader getting long this spread would be $0.66 x 1 x 100 = $66, or $66 per contract traded.
This episode of Best Practices has other examples of the BPR for undefined risk trades like short strangles, as well as an explanation of why the calculation of BPR can differ in a traditional margin account versus an IRA. We encourage you to watch the entire episode for a full account of these examples and explanations.
As always, we invite you to contact us at firstname.lastname@example.org with any questions or feedback.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.