Level 3 — Exposure

What Level 3 adds: options with nothing behind them

At Level 2 every written option had a bought option, shares or cash behind it, so the worst case could be written down before the trade. At Level 3 at least one written option in most structures stands alone. Its loss runs until the index or share stops moving, and what the account must hold against it is set by a margin formula that rises exactly when the position is losing.

Two of the seven structures keep a capped loss: the backspread and the broken-wing butterfly, which belong here because they are built from uneven numbers of options and are priced off the volatility skew. The other five (the short straddle, the short strangle, the jade lizard, the ratio spread and the uncovered call) each carry a written option that no bought option covers. Everything on this page is about those five: how much a broker holds, how to test what a bad week would do, what the broker does when the money runs short, and how large the bad days have been.

The page assumes the spread margin and assignment pages, and the volatility skew, which is what the backspread, ratio and broken-wing structures trade.

Seven structures on one FTSE 100 chain

Model inputs. Tuesday 1 September 2026, the FTSE 100 at the model level of 10,750 (it closed between about 10,600 and 10,900 in August and September 2026; price data: Yahoo Finance). ESX options expiring Friday 16 October 2026, 45 days away; £10 a point; European and cash-settled. Implied volatility from the library's FTSE surface, IV(K) = 14.0% − 0.40 × ln(K / 10,750), held per strike, from 16.10% at 10,200 to 11.83% at 11,350; Bank Rate 3.75%; dividend yield 3.05%. Fills on the 0.5-point tick at the model value: 10,200 put 54.5, 10,250 put 62.0, 10,400 put 91.0, 10,500 put 116.0, 10,750 put 205.5 and call 214.5, 11,000 call 101.0, 11,100 call 69.5, 11,200 call 45.5, 11,250 call 36.0, 11,350 call 21.5. The stress columns are instant moves on the entry day with every strike's volatility shifted by the stated amount. The requirement applies the Cboe broad-index formula as a yardstick; each strategy page states its own stress shifts.

Three things stand out. The requirement dwarfs the credit on every uncovered structure: 4.8 times it for the straddle, 13.3 for the strangle, 19.2 for the uncovered call and 154 times the ratio spread's small credit, which is why returns quoted on the premium look far larger than returns on the capital a broker actually holds. The ratio spread and the backspread are the same two strikes turned round: after the 20% fall one shows −‍£14,415.95 and the other £14,415.95, the whole difference between writing the extra put and buying it. And the uncovered call is the mirror of the put-based structures: a small gain after the 20% fall and its largest loss in the 10% rise, where the jade lizard and the put ratio lose nothing and the backspread only its small debit.

The thumbnails draw each at the 16 October expiry from 9,600 to 11,900, each to its own scale; the dashed line is 10,750, the dotted lines the strikes.

Uncovered margin: the published formulas

For options with nothing behind them, US exchange and FINRA rules publish the formula most strategy-based margin systems start from (Cboe Margin Manual, 30 November 2021; FINRA Rule 4210(f)(2)(E)). A broker may ask for more, since FINRA Rule 4210(d) requires firms to review the need for requirements higher than the rule's minimums, and a UK broker margins ICE contracts under its own policy. The order preview is the figure that applies; the formulas show where it comes from.

Model inputs for the worked table. A hypothetical US share at $100 (not a real company): 60 days, IV 30%, dollar rate 3.625%, the $95 put valued at $2.46 and filled at $2.45, the $105 call at $3.07 and $3.10. BP at the model level of 530p on the Level 1 chain: the 500 put at 9.04p (filled 9.00p) and the 560 call at 11.97p (filled 12.00p), 60 days, IV 26%. The FTSE 100 strangle legs above. Each option is roughly 5% out of the money.

Spreads are held differently: at their maximum loss, because a bought option caps the written one (spread margin). A covered call needs nothing beyond the shares.

Two comparisons carry the lesson. A BP 500 put costs £5,000.00 of cash to write in a cash account and £850.00 in a margin account; the difference is borrowed capacity, and the margined version is a Level 3 position even though the option is the same one that sat in Level 1's table. And a strangle needs little more than its larger side (£970.00 against £880.00 on BP), because both sides cannot lose at once at expiry; they can both lose on the way there, which is what the next section tests.

A stress test in five steps

The requirement at entry says nothing about the requirement after a bad day. The library's stress test asks what a set of moves would do to the position and to the money the broker holds, before the position is opened:

1. Choose the moves. One and two standard deviations each way over the option's life (lognormal, at the model's IV), and a 20% gap down. The 20% gap is not arbitrary: the FTSE 100 fell 21.7% over 19 and 20 October 1987 (gap history).
2. Move volatility with the index. Falls lift implied volatility and rises lower it. This page shifts every strike's volatility by the same stated amount on top of its skew: +2 points at −1 SD, +4 at −2 SD, +20 on the 20% gap, −1 and −2 points at +1 and +2 SD, as the short straddle, short strangle and jade lizard pages do. Other strategy pages state their own shifts: the 60-day ratio, backspread and broken-wing pages use +3, +7 and +18 points; the uncovered call page raises volatility on a rise, where a bid or a squeeze would sit; and the sizing page's single-share tests add 5 points on a 10% fall and 10 on a 20% fall.
3. Reprice every leg instantly, on the entry day, so the result is the move's effect and not time decay's.
4. Recompute the requirement at the new index level, using the options' new values.
5. Add the two: the equity needed at the start so that, after the marked loss, the account still meets the new requirement.

Applied to the FTSE 10,200/11,250 strangle, the same position and figures as the short strangle page, which carries the full seven-row table:

The 20% gap marks the strangle at 17.1 times its credit. An account that started with less than £44,753.80 would be below its requirement the moment the index opened there, with one contract.

The same test on a US index ETF, in dollars and pounds

Model inputs. A hypothetical US-listed ETF tracking a broad-based index, at $500 (not a real fund), on the same dates: 45 days, a flat IV of 18% (no skew modelled, an assumption), dollar rate 3.625% and no distribution in the window (assumed). American options on 100 units, in a penny-tick class: the $470 put (model $2.337, delta −‍0.14) filled at $2.34, the $535 call (model $2.718, delta 0.17) at $2.72: a credit of $506.00 (£373.18 at $1.3559). The broad-index 15% rule applies to an ETF tracking a broad-based index: $5,506.00 (£4,060.77) at entry.

Two UK points sit behind the dollar figures. An assigned put on an ETF delivers fund units, and gains on units of an offshore fund without reporting status are taxed as income rather than capital gains, so the fund's status matters before the put is written (US ETFs and offshore funds). And the marks convert at the day's rate: a dollar loss can become a larger or smaller sterling loss without the ETF moving (two dates, two rates).

The margin spiral: when equity falls below the requirement

In a margin account the broker compares two numbers all day: the account's equity, which falls as a written option's value rises, and the requirement, which rises for the same reason. When equity drops below the requirement the account has a deficit. Interactive Brokers states the consequence plainly for a margin account: margin "is calculated on a real-time basis" with "immediate position liquidation if minimum maintenance margin requirement is not met" (IBKR UK account-type table), and "if your account equity moves rapidly from a greater than 10% cushion to a margin violation, your positions may be liquidated without you receiving a yellow warning" (IBKR margin-monitoring guide; both checked 28 September 2026). The broker chooses what to close and when.

Model inputs. The FTSE strangle above, written on Tuesday 1 September in an account holding £25,000. An assumed path, not a forecast: the index falls to 10,320 by Tuesday 8 September, 9,890 on the 9th, 9,460 on the 10th and 8,815 on the 11th, with volatility at every strike 4, 10, 15 and 20 points higher. Each day's marks use the options' remaining life.

The two lines cross on Thursday 10 September. Between 1 and 10 September the index fell 12%, equity fell by £7,696.18 and the requirement rose by £10,761.18: the spiral is that both move against the account at once. A broker that liquidates in real time buys the strangle back that day. At the model's values plus half of an illustrative 10-point stressed quote on each leg (£100.00 in all) and commission, the buy-back costs £8,704.48, and the trade ends at −‍£7,802.88. Had the index recovered to 10,300 by 16 October, the strangle would have settled with both options out of the money and kept £901.60; the liquidation fixed the loss at the low point, on the broker's timing. The stress test in the previous section is the way to see the crossing point before the trade: here, somewhere between an 8% fall with volatility 10 points higher and a 12% fall with volatility 15 points higher.

Sizing turns this into a limit on how much of an account one position may use: the sizing page's undefined-risk lines cap the initial margin and the loss in an instant 20% move, worked on a written BP put, and its sizing framework sets them beside the other lines.

The FTSE 100's worst days, and what each does to a strangle

A stress test is only as good as its moves. The table sets the FTSE 100's four largest one-day falls since daily data begin in January 1984, and two other days discussed below, against the strangle above: the same percentage fall applied instantly to 10,750 on 1 September, with volatility unchanged and 10 points higher. Price data: Yahoo Finance daily closes, checked 28 September 2026.

• The falls come in clusters. 1987's two days together took the index from 2,301.9 to 1,801.6, 21.7% lower, equivalent to 10,750 falling to 8,414; March 2020 had its −7.69% and −10.87% days in the same week. A test that allows one bad day and then a recovery understates the path.
• The lognormal model does not expect these days at all. At the model's 14% volatility, a one-day fall of 5% or more has a probability of about one in 323 million per trading day, so across the 10,794 trading days in the data it would be expected 0.000033 times. It happened on 20 days, and falls of 10% or more on 3. The model prices options; it does not describe the tail.
• August 2024 was a volatility gap more than a price gap. The FTSE 100 fell 2.04%, while Japan's Nikkei 225 fell 12.40% that day and the US VIX index went from 23.39 to an intraday 65.73 before closing at 38.57 (Cboe VIX history). On the strangle, a 2.04% fall alone marks it at −‍£240.29; the same fall with volatility 10 points higher marks it at −‍£2,364.25, and the volatility rise on its own at the entry level accounts for −‍£2,255.54 of that. A short-volatility book is marked on implied volatility, not only on the index.
• The highest VIX close on record is 82.69, on Monday 16 March 2020 (Cboe VIX history, daily data from 1990). The FTSE 100's own implied volatility index is described on the implied volatility page.

For a written call on a single share the gap usually runs the other way. Under the Takeover Code, an announcement that starts an offer period must name any potential bidder in talks (Rule 2.4), and a named bidder then has 28 days to make a firm offer or walk away (Rule 2.6(a)); the share can open near the offer price with no trading in between. The uncovered call page works a takeover gap in pounds.

No negative-balance protection for listed options

UK retail clients trading CFDs and spread bets have a floor under their losses. COBS 22.5.17R: "The liability of a retail client for all restricted speculative investments connected to the retail client's account is limited to the funds in that account." The FCA defines restricted speculative investments as leveraged contracts for differences, leveraged spread bets, leveraged rolling spot forex contracts and "restricted options", which are options in the money when sold, whose value moves one for one with the underlying and is not significantly affected by time to expiry (FCA Handbook glossary). An ordinary exchange-traded option is none of these, so neither the protection nor the 50% margin close-out rule in COBS 22.5.13R applies to it.

The broker's terms fill the gap. On its margin requirements page Interactive Brokers says that "a client remains liable to Interactive Brokers for any debt or deficit in an account" (IBKR UK, checked 28 September 2026). In the strangle's terms: two contracts fit inside a £25,000 account at entry, with a combined requirement of £24,060.00. A 20% gap overnight, with volatility 20 points higher, marks them at −‍£30,948.80, and the account opens at −‍£5,955.60, a debt owed to the broker before any position can be closed.

Two other safety nets do not help here. The FSCS protects up to £85,000 if an authorised investment firm fails; it does not cover investment losses. And the same short-volatility exposure taken as a spread bet would carry the COBS 22.5 protections but a different tax treatment and different contract terms, compared on the spread bets page.

Tax at Level 3: cash flow and status, not tax on a loss

A written option is not taxed as a gain when the final result is a loss. For exchange-traded options the three ways a losing written option ends all recompute its result:

What Level 3 does change is cash flow and timing. Losses on large positions arrive in days, while relief comes through a return filed months later, and a capital loss can only be set against capital gains: first against the same year's gains, then carried forward, never back (GOV.UK, Capital Gains Tax losses; claims within four years). A cash-settled FTSE option written in March and settled at a loss in April lands in the later tax year, while one that lapses lands in the grant year; the tax page works that case (Example 5) and the general 5 April rules.

Trading or investing. HMRC's view is that dealing in shares and financial instruments by an individual is normally not a trade, and that individuals are unlikely to carry on a trade of dealing in options; in Salt v Chamberlain about 200 transactions over several years, including options, were held not to be trading (BIM56850, BIM56860, CG55402). Frequency alone does not settle it; the badges of trade and the SA108 consequences are set out on the Self Assessment page.

Wrappers. No ISA can hold an option. HMRC's rules allow options in a registered pension scheme but tax a scheme's trading income (PTM121000), and the two SIPP administrators listed by Interactive Brokers both exclude options; we could not find a UK SIPP administrator that permits uncovered option writing (checked 26 September 2026). Details: options in a SIPP.

The seven structures, in the order the course teaches them

The course has no fourth level. Beyond these seven there is no new shape to learn, only larger size, more positions and portfolio margin applied to the same shapes. Portfolio margin at IBKR is an optional account type (options approval and at least USD 110,000 of net liquidation value to switch to) that calculates the requirement from the risk of the whole account; it does not grant the right to write uncovered options: that comes from the options permission level (Level 3 for an uncovered put, Level 4 for uncovered calls, short straddles and strangles) in an ordinary margin account (accounts and permissions).

Pages that apply Level 3

Each carries its own stress table and applies this page's formulas to one structure:

Self-check: ten questions on Level 3

Not scored, and not a requirement. Each answer uses this page's numbers.

How these numbers are calculated