When you open a brokerage account, you'll have the option to choose between a cash account and a margin account. If you want to buy options, you can use either a cash or a margin account. However, cash accounts are more restrictive when it comes to option strategies. If you're looking to implement a more advanced options trading strategy, you might have to open a margin account.
You do not necessarily need a margin account in order to purchase options. You can also purchase options using a cash account, although your opportunities may be somewhat more limited.
Cash Account vs. Margin Account
As the name implies, in a cash account, you'll need to have enough cash to cover the value of any potential trade. If you're simply buying options, this means you'll have to have the total value of your trade sitting in cash in your account.
With a margin account, you're allowed to borrow money to execute your trades. Unlike a cash account, you don't need the full value of your trade sitting in cash in your account. Buying and selling on margin is riskier than paying for trades in cash. Since you only have to put up a portion of the amount of your trade, you're using leverage. Leverage, or the use of borrowed monies to fund a trade, amplifies both gains and losses, so you have the potential to gain or lose more money if you trade on margin.
Types of Option Trades
Options come in two types: calls and puts. A call option gives the buyer the right to buy a stock at a certain price within a certain time period. A put option is the opposite, giving the buyer the right to sell stock at a certain price within a certain time period.
If you buy calls or puts, your potential loss is limited to the amount you pay for the trade. Thus, these types of trades are allowable in cash accounts. In the worst-case scenario, your option will expire worthless, and you'll lose the total amount of your investment. However, you won't have to put up any additional money.
If you sell calls or puts, you're selling a potential liability in exchange for an upfront premium. For example, if you sell a put, you're giving someone else the right to make you pay a certain price for a stock. Although your loss is defined by the strike price of the option contract, that amount could be more than the premium you earned by selling the stock.
Example of Option Trades
Here's an example. If you sell an IBM Oct 150 put, you are giving the buyer the right to "put" 100 shares of IBM to you at $150 per share anytime the option expires in October. That creates a potential liability of $15,000, or $150 per share times 100 shares. If you earned $1,000 from the sale of your put, you have an outstanding potential liability of $14,000.
If you sell a call, your loss could theoretically be unlimited. This is because you are selling the right to have someone take shares of stock away from you at a certain price. If you already own the stock, you can simply hand over the shares. However, if you don't own the stock, you'll have to go buy it at the current market price. If the stock has gone up significantly in price, you could be facing a huge loss.
Since these types of options strategies involve the potential for loss greater than the amount you have in your account, you must execute them in a margin account only.