Last updated on September 21st, 2022 at 01:27 pm
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Trading options will always remain attractive to people looking to generate above-average or outsized returns from the market. However, the trading environment is aggressive, requiring caution and proper knowledge to succeed.
Can you owe money with options if you fail with your trades?
If you are buying put or call options with cash in your brokerage account there is no way for your options to go into the negative. You can go in the negative or owe money with options if you borrow money (use margin) or sell naked options.
Borrowing money to trade options can leave you in debt from the interest charged by the broker. Selling naked options can also leave you owing thousands in stocks if your option is assigned.
Those are the only two cases where your account can go in the negative with options. Most people who trade options buy and sell calls and puts.
When buying calls and puts you cannot go into debt when trading them (again assuming you aren’t using a margin account). If the price of the option goes to zero you can lose the premium you paid for that option but can’t lose more than that.
The rest of the article will look at the various ways you can owe money as an options trader. You’ll also learn what to do to avoid these situations.
How People Go In The Negative With Options Trading
Many options brokers have mechanisms and systems in place to make sure their clients don’t end up with a negative balance or in debt. These systems include:
- Liquidation levels
- Healthy margin requirements
- Requests for collateral on positions
- The ability to auto-reject options assignment
You’re likely to find these “safety nets” on most retail options trading platforms where the brokers try to protect the average trader from themselves. However, these options do not exist on some types of accounts (or with some brokers).
Thus, a trader stands the risk of going into negative or owing money.The debt scenario will only happen in one of the following two ways.
Let’s take a look at them now.
Borrowing Money For Trading
If you borrow money for trading, you’ll have to repay the money borrowed and the interest.
If the trade goes in your favor, you can keep your profit after repaying the loan and interest. However, if the trade goes wrong, you could end up owing all or some of the borrowed sum, in addition to the interest charged.
For example, if you borrowed $100,000 at 5% interest for a month, you need to make at least a 5% return on the position to break even and avoid debt. If your trade returned a nice 15% over the period, you’d have made $10,000—a sum which would be unrealistic if you had to come up with the entire $100,000 capital on your own.
On the flip side, if that trade went negative by 10%, you’ll owe the lender $15,000, which is the amount lost from the capital and the interest that is owed.
The exact numbers of this scenario will come down to whether you’ve borrowed from your broker or a third party and the terms of the loan. All businesses in the options space don’t have the same rules in this space.
Some brokers only leave the loan for as long as your deposit amount is still in play.
So, if you have a capital of $5,000 and you borrowed $50,000, they’ll close your position and take out the borrowed sum if you go in the negative and the position is $4000+ in the red.
The approach ensures you don’t owe them, but you’d have lost your trading capital.
So, you should check the terms and conditions before borrowing to ensure you won’t go into debt when using margin to trade.
Many professional traders advise staying clear of all forms of borrowing in options trading, while others say leverage is a powerful tool. For newbies, the former advice is the better one to listen to.
When you’re adequately grounded in your trading, you can explore the careful use of leverage and other forms of borrowing.
Selling Naked Options
In options trading, you typically need to have shares of a specific stock to sell calls. However, some brokers will allow you to sell naked options, which means you don’t hold any positions in the underlying shares.
Many options contracts never get assigned or expire worthless, so selling naked options is usually risk-free in terms of debt accumulation, until it isn’t.
If you sell a naked put on AMZN now and don’t have a position on the stock, you have to buy the shares if the option is assigned to you. It’s at this point that people get into trouble.
In such a scenario, you have to buy the shares. Of course, you can only do it with cash or borrowed money.
If you don’t have the cash, you’ll have to borrow the money either from your broker or a third party, leaving you in debt.
One of the most publicized examples of how unexpected assigned options can destroy your trading account and leave you in debt is the story of the Reddit user Ir0nyman. His box spread strategy involved naked puts and went well for some time before it all came crashing down as he lost 2000% in one day.
Fortunately, as is the case with borrowing, many retail brokerages also have processes in place that keep newbies from going into debt on naked puts.
On some options accounts, you’ll need to have enough cash or stocks before you can sell options. Cash-secured puts ensure you’ll have enough cash to buy the stock if a contract is exercised and assigned.
Covered calls ensure you’ll have enough stocks to sell if your call option is assigned.
Your broker will allow you to purchase shares and fulfill the assigned contract using a margin account on higher-level options accounts. With the margin account, you can borrow money from the broker to purchase securities.
The brokerage will charge interest on this transaction.
How Can You Avoid Going Into Debt With Options Trading?
You can avoid going into debt with options trading by staying clear of strategies that rely on selling naked options. You also need to understand the terms and conditions before using your margin account to borrow money from your brokerage or borrowing from a third party to trade.
It’s possible to owe money with options trading, but the possibility of that happening is rare as it’s only in two specific scenarios that it’s possible. Unfortunately, the trader affected could be left with large losses the few times it does happen, as we saw in the example above.
You can avoid such scenarios by only trading with brokers that have mechanisms in place to protect you from debt or negative balance. Such brokers will automatically pull the plug on a position before it becomes too damaging.
They may also allow you to set breakers manually, such as allowing you to set the “Do Not Exercise” option.
You can also just only buy and sell traditional options (puts and calls) with a cash account to avoid these two possible scenarios. You can lose money trading options this way but you can never lose more money than you actually have.