What You Should Know About Option Margin

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