Can You Avoid a Margin Call by Hedging Short Positions with Call Options?

Introduction:

Hedging your short position by buying call options can be a strategic move to avoid a margin call from your broker. This technique utilizes options as a form of insurance, potentially stabilizing your overall position and maintaining sufficient equity in your account. However, it is essential to understand the nuances and limitations of this approach.

Understanding How Hedging with Call Options Works

Short Position: When you short sell a stock, you borrow shares and sell them with the expectation of buying them back at a lower price. If the stock price rises, your losses can increase to the point where your account equity falls below the required maintenance margin, leading to a margin call. Buying Call Options: By purchasing call options on the same stock, you gain the right to buy the stock at a predetermined price (strike price) within a certain timeframe. This can act as insurance against the stock price rising. Offsetting Losses: If the stock price increases, the losses from your short position can be offset by gains from your call options. This can help stabilize your overall position and maintain sufficient equity in your account, potentially preventing a margin call.

Considerations

Cost of Options: Buying call options involves paying a premium, which is an additional cost that can impact your overall profitability. This premium can eat into your potential gains. Market Movements: If the stock price rises significantly, your call options may not cover all your losses, especially if the price increase is substantial. Brokerage Policies: Different brokers have varying margin requirements and policies regarding hedging. It is crucial to check your broker's specific rules to understand how the risk is managed. Liquidity: Ensure that the options you buy are liquid enough to sell if needed. Illiquid options can be more challenging to exit and may not provide the flexibility you need.

Conclusion

While hedging with call options can reduce the risk of a margin call, it does not eliminate it entirely. It is still crucial to monitor your positions closely and understand the risks involved in both short selling and options trading.

Additional Tips for Using Margin with Call Options:

Within the overall limits of your margin maintenance rules for your specific account and broker, you can use on-margin to open positions. Opening two separate option positions at different times might have different margin implications than opening them simultaneously. For example, in my Schwab IRA account, I have been granted Level 2 Options trading, which allows the use of verticals such as Bull Put Spreads and Bear Call Spreads. In this situation, the net total loss difference of the strikes is what is accounted for as the "margin" requirement.

However, if you were to first buy a put and then later sell a put on the same stock with the same expiration date, each transaction would be accounted for separately, and your "margin" amount would be the potential total loss on the sold put.

Other brokerage accounts may account for margin a bit differently. Therefore, it is always best to verify the rules with your individual brokerage account manager.