Buying power, margin and liquidity

Two practical constraints sit between an option idea and a filled order: whether your broker will let you place it, and whether the market will let you get out of it at a fair price. Both are ignored in most beginner material and both cost real money.

Approval levels

US brokers assign option approval levels based on experience and account type. The names vary; the tiers are broadly:

Level	Typically allows	Account type
1	Covered calls, cash-secured puts (sometimes protective puts)	Cash or margin
2	Buying calls and puts outright	Cash or margin
3	Spreads (verticals, calendars, iron condors)	Margin required
4	Naked (uncovered) short options	Margin, higher equity minimums

Spreads require a margin account even though their risk is defined, because the short leg is technically a short option. If you are in a cash account, you can buy options and sell covered ones, and that is all. Upgrading is a form and usually a day; know your level before planning a strategy that needs a higher one.

Buying power for each structure

What the broker holds against a position, in the usual US retail framework:

Position	Buying power held (typical)	Example on XYZ at $50
Long call or put	100% of premium	$50 call at $2.40: $240
Debit spread	Net debit	50/55 for $1.70: $170
Credit spread	Width − credit	45/40 put for $0.45: $455
Cash-secured put	Strike × 100 (in a cash account)	$47 put: $4,700
Naked short put (margin)	Roughly 20% of stock value − OTM amount + premium, with a minimum of 10% of strike	$47 put: about $700 to $1,000
Naked short call (margin)	Similar formula; unlimited risk, so subject to higher house rules	$53 call: about $800 to $1,100
Covered call	Stock margin as usual; call requires nothing extra	100 shares at $50

The naked short put line is the one that causes trouble. Selling the $47 put in a margin account ties up perhaps $850 of buying power against a $4,700 obligation. That is 5.5-to-1 leverage on the downside of the stock, and it makes it possible to sell five such puts on a $5,000 account. If the stock drops 20%, the loss is roughly $2,000 per contract on a position that "cost" $850. Margin buying power is not the risk; strike × 100 is the risk.

Buying power for short options also rises as the position moves against you and as IV rises, which is exactly when you have the least spare. A margin call on a short option position forces liquidation at the worst prices. Keep a large cushion of unused buying power if you sell premium at all; a common rule is to never commit more than 30% to 50% of available buying power to short-option requirements.

Liquidity: open interest and volume

Before entering any option, check three things on the chain:

Open interest: contracts outstanding. Under a few hundred is thin; under fifty means you may not be able to exit at a fair price.
Volume today: contracts traded. Zero volume on the strike is a warning; you may be the only participant.
Bid-ask spread: the cost of getting in and out. This is the one that matters most.

The bid-ask spread as a cost

The spread is a cost you pay twice: once on entry, once on exit. Measure it as a percentage of the mid-price.

Option	Bid	Ask	Mid	Spread	Spread as % of mid	Round-trip cost per contract
Large-cap ATM, 30 days	1.88	1.92	1.90	0.04	2.1%	$4 (if you cross both ways)
Mid-cap ATM, 30 days	1.80	2.00	1.90	0.20	10.5%	$20
Small-cap OTM, 60 days	0.35	0.60	0.475	0.25	52.6%	$25 on a $47.50 option
Deep ITM, any	6.00	6.80	6.40	0.80	12.5%	$80

The small-cap OTM line is a trade with a 53% spread. Even if you get filled at mid on both sides, you will typically give up a quarter of the spread each way, or about $12.50 round trip on a $47.50 position: 26% of the premium spent on transaction cost before the stock moves. On a credit spread with two such legs, the entire credit can be smaller than the spread cost.

A workable rule: do not trade options whose bid-ask exceeds 5% of the mid for single options or 10% of the credit or debit for spreads. If the market is wider than that, the underlying is not liquid enough for options, whatever the chart says.

Key idea: Margin buying power for short options is a fraction of the obligation, which is how small accounts get over-leveraged. The bid-ask spread is a round-trip cost that can exceed a trade's entire edge; measure it as a percentage of mid before every order.

Getting a fair fill

Always use limit orders. Place the limit at the mid or slightly worse and wait; on liquid options you will usually be filled within a minute. If not, step toward the market a cent or two at a time. Never use a market order on an option; the fill can be at the full width of the spread, and on thin options that can be a large fraction of the premium.

Spreads should be entered as a single order (a "vertical" or "spread" order type) with a net limit. Legging in, which is placing the two legs separately, is covered in the last lesson and is a common source of losses.

Time of day

Bid-ask spreads on options are widest in the first fifteen minutes and the last few minutes of the session, and around major scheduled data releases. Market makers widen quotes when they are uncertain. Enter and exit in the calmer middle of the day unless the trade specifically requires the open or close.

Try it: Pick three underlyings: a large-cap, a mid-cap and a small-cap. For each, record the bid, ask and open interest on the ATM 30-day call and a 15-delta put. Compute the spread as a percentage of mid for each. Decide which of the six options you would be willing to trade under the 5% rule.

Recap

Broker approval levels gate strategies; spreads need a margin account even though their risk is defined.
Margin buying power for naked short options is a small fraction of the obligation; size on strike × 100, not on buying power, and keep a large cushion.
Check open interest, volume and bid-ask before every option order.
Measure the spread as a percentage of mid; avoid single options over 5% and spreads over 10% of the net price.
Use limit orders at or near mid, enter spreads as single orders, and avoid the first and last minutes of the session.