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Why are vertical spreads (e.g., buying a call at one strike and selling a call at another strike, at the same expiration date) classified as "Level 3" options strategies, therefore requiring margin?

As far as I can see the maximum loss is the cost of acquiring the spread position.

I understand that it's possible for the short leg of the trade to be assigned before expiration, but in that scenario the broker can immediately exercise the other leg to avoid any carry cost.

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If the short leg is assigned early, the broker cannot immediately exercise the other leg, because the assignment notification process occurs overnight. The offsetting exercise obtains the needed cash or stock, but only the trading day after it was needed, incurring one day's interest. See this question.

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As noted, the margin for a vertical debit spread is the cost of the position and that is the maximum loss. The same position can be put on with a credit spread in which case (synthetic), the margin is the difference in strikes less the premium received. In both cases, the loss is limited.

However, option approval levels aren't solely based on the margin requirement, if any. Per regulations, option approval levels are designed to to provide protection for both the broker and the customer. Higher trading approval levels requires that one demonstrate trading knowledge, experience and the income to support the positions taken. It's essentially a vetting system.

Spreads are considered to be a more sophisticated strategy than buying long options or selling covered calls so they are designated at a higher approval level.

  • You were the one who taught me (in the comments of the question I linked) that a spread requires one day's borrowing in the case of early assignment. Isn't that a more direct reason it must be done in a margin account? – nanoman Jul 15 at 16:08
  • My answer focused on the reason that spreads require a higher level of trading approval. The OP has a point about a debit spread having no margin risk but given that the synthetic via a credit requires margin, it wouldn't make any sense to have two levels for verticals spreads so they're all lumped into Level 3. However, I didn't address why a margin account is necessary in terms of exercise and since you explained that quite clearly in your answer, I won't update my answer. – Bob Baerker Jul 15 at 16:38

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