What You Should Know About Option Margin

Before doing any options trades, beginning and even experienced option traders should be aware of some points about option margin rules. First, very simply, margin is the money that a trader must deposit into his or her trading account in order to trade options (or futures). This is not the same as margining stock. Margin for stock positions is completely different from the concept of options margin: margining a stock position is actually a loan to you from your broker so that you can buy more stock with less of your own capital, and you are typically charged at a short-term market rate of interest. Margin for options (and futures), on the other hand, is a cash or cash equivalent deposit that can earn interest while it works for you, since you are generally permitted to hold short-term Treasury Bills as margin by many brokers.

For example, to sell a simple bear call credit spread (long and short an out of the money call that produces a credit) on the S&P 500, you would need to have sufficient margin (also known as a "good-faith" performance bond) in your account to open the position, but not the maximum amount of the total risk if using the SPAN margin system used by most exchanges. Buying options outright, on the other hand, typically does not require any deposit of margin because the maximum risk is what you pay for the option. Essentially margin, therefore, is what the broker requires you to have in your account if you want to implement (and maintain) an option selling strategy.

For a typical ‘one-lot' (i.e. simple 1 x 1) credit spread position, margin requirements, depending on the market involved, can range from as low as a few hundred dollars (on grains like soybeans, for example) to as much as several thousand dollars (on the S&P 500, for instance). A good rule of thumb for writers, by the way, is that the ratio of margin to net premium collected should be at least 2-to-1. That is, you should try to find option trades that give you a net premium that is at least one-half the initial margin costs.

Note that above I referred to “initial margin” costs: one additional point about option margin is that it is not fixed in most cases. In other words, initial margin is the amount required to open a position, but that amount can change with changes in the market. It can go up or down depending on changes in the underlying, time to expiration, and levels of volatility. Another margin concept is maintenance margin, which is a floor amount required by your broker to keep a position open. To better understand how this works, we need to talk about SPAN margin, which is the margin system developed by the Chicago Mercantile Exchange (CME) and used by all traders of options on futures. For most stock and stock index options traders, margin rules are set according to a different set of rules, and often require the posting of the maximum loss as a margin deposit in the case of spreads like the one mentioned above (which would be the distance between the strikes minus the premium received).

The SPAN System

For option writers using futures options, SPAN (Standardized Portfolio Analysis of Risk) margin requirements offer a more logical and advantageous system than ones used by equity option exchanges (which tends to be more arbitrary in terms of the relationship of margin required to actual risk). It is, however, important to point out that not all brokerage houses give their customers SPAN minimum margins. If you are serious about trading options on futures, you must seek out a broker who will provide you with SPAN minimums. The beauty of SPAN is that after calculating the worst-case daily move for one particular open position, it applies any excess margin value in your account to other positions (new or existing) requiring margin, and even in different markets.

Futures exchanges predetermine the amount of margin required for trading a futures contract, which is based on daily limit prices set by the exchanges. This predetermined amount of margin required by the exchange is based on what a ‘worst-case' one-day move might be for any open futures position (long or short). When looking at options or combined options and futures positions, meanwhile, risk analysis is done also for ‘up’ and ‘down’ changes in volatility, and these are built into 16 so-called ‘risk arrays’. Based on these variables, a this set of 16 risk arrays is in fact created for each futures option position. A worst-case risk array for a short call, for example, would be futures limit extreme move up or down on the day.

Obviously, a short call will suffer from losses from an extreme (limit) move up of the underlying futures. SPAN margin requirements are determined by a calculation of the possible losses in a given day, taking into account distance and direction of futures, up or down volatility and extreme moves. The margin requirement is always set at the biggest potential loss found in any one array. The uniqueness of SPAN, however, is that when establishing margin requirements it takes into account the entire portfolio, not just the last trade.

The Key Advantage of SPAN

As I mentioned above, the margining system used by the futures options exchanges provides a special advantage of allowing Treasury Bills to be margined. Interest is earned on your performance bond (if in a T-Bill) because the exchanges view Treasury Bills as margin-able instruments. These T-Bills, however, do get a "hair cut" (a $25,000 T-Bill is margin-able to the value between $23,750 and $22,500, depending on the clearing house). Because of their liquidity and near-zero risk, T-Bills are viewed as near-cash equivalents. Because of this margining capacity of T-Bills, interest earnings (depending on the level of the short-term rates in the market) can sometimes be quite sizable, which can pay for all or at least offset some of the transaction costs incurred during trading--a nice bonus for option writers.

SPAN itself offers one key advantage for option traders who combine calls and puts in writing strategies. Let me provide an example of how you can acquire an edge. If you write a one-lot S&P 500 call credit spread, which has the near leg at about 15% out of the money with three months until expiry, you will get charged approximately $3,000-4,000 in initial SPAN margin requirements. SPAN assesses total portfolio risk, so, when/if you add a put credit spread, you generally are not charged more margin if the overall risk is not increased according to SPAN risk arrays.

Since SPAN is logically looking at the next day's worst-case directional move, one side's losses are largely offset by the other side's gains. It is never a perfect hedge, however, because rising volatility during an extreme limit move of the futures could hurt both sides. Nevertheless, the SPAN system basically does not double charge you for initial margin on this type of trade, which is known as a "covered short strangle" (AKA, iron condor) because one side's risk is mostly canceled by the other side's gains. This basically doubles your margin power. An equity or index option trader working with non-SPAN margin systems does not get this favorable treatment when operating with the same strategy, although some brokers have now begun to give traders a break on this double charge. Even so, there are several other strategies, like diagonal time spreads and conversions that will get a better margining with SPAN than under rules in use elsewhere.

I hope this helps clarify any confusion you may have had about how margin works for options.

John Summa


 

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