5 Things you Should Know about Options on Futures Margin
The truth is, unlike margin on futures contracts, option margin is dynamic. It is almost constantly changing along with market price, volatility, and the exchange’s perceived event risk. Further, many brokerage firms opt to charge their clients margin requirements that are higher than the exchange minimums to compensate for what they believe to be additional risk posed to the client, and more importantly themselves. Accordingly, one will probably never fully understand option margin but it is worthwhile to be aware of the basics to ensure proper strategy development and implementation.
According to the CMEGroup.com, Standard Portfolio Analysis of Risk, commonly known as SPAN, is a “sophisticated methodology that calculates performance bond requirements by analyzing the “what-ifs” of virtually any market scenario.” SPAN was developed and implemented in 1988 by the Chicago Mercantile Exchange; it is now owned and operated by the CME Group (the mega-conglomerate of U.S. futures exchanges). It is now the industry standard for risk calculation and, therefore, represents the exchange minimum margin requirement for options and futures trades.
SPAN is the commodity equivalent of “portfolio margining” in stock trading
The beauty of SPAN is that it accounts for a traders’ portfolio of holdings rather than margining each position individually. This means that traders executing antagonistic trades will receive a margin break. For instance, a trader buying an S&P 500 futures contract and then selling a call option against it, can only lose on one leg of the trade or the other, but not both. This is because the positions benefit in the opposite outcome. Similarly, a trader that sells both a call and a put, will not be charge full margin on both sides of the trade because it would be impossible to lose on both the call and the put. As a result, such trades are margined at a lower rate than would be the case if the exchange ignored the correlation of positions and charged full-margin on each.
Stock traders are likely aware of a method of brokerage firm risk assessment known as “portfolio margining”. Similar to SPAN, clients enjoying portfolio margin calculations in their stock account are provided discounts when holding positions that can be considered hedges to one another. However, stock traders will also tell you that gaining access to such a margining system requires a little work, and a decent amount of money. Brokerage firms typically won’t offer this luxury to clients trading accounts less than $100,000.
Futures and options traders, on the other hand, are offered portfolio margining in the form of SPAN, regardless of account size. This is assuming their brokerage firm honors SPAN minimums; we’ll get into that shortly.
SPAN margin should be a starting point when determining account funding
The goal of SPAN is to evaluate the risk of a particular trading account by calculating the “worst” possible loss that could reasonably incur in a single trading day. However, most industry insiders agree that SPAN becomes less accurate as the strikes price of the options in question get deeper-out-of-the-money. Additionally, there is no such thing as a worst case scenario because we truly don’t know how extreme market prices can get in any given trading session. Of course, the odds of such extremes occurring are rare, but anything is possible. For instance, on May 10th 2010 the S&P 500 futures dropped further and farther than SPAN had accounted for. Traders who were fully margined going into the day, discovered that losses not only surpassed their daily margin requirement but, in many cases exceeded their account balance!
Accordingly, traders shouldn’t assume their SPAN margin requirement is necessarily the worst case scenario. Instead, traders should leave plenty of excess margin in their account to provide a cushion to something beyond SPAN’s assumption of the “worst case scenario”.
I recommend that clients attempt to keep the margin used in their account to 50% of the total account balance, or less. Thus, a client trading with a $10,000 account could comfortably hold positions that require $5,000 or less in margin. Unfortunately, most traders view excess margin as a wasted opportunity. As a result, they will try to use all $10,000 of their $10,000 trading account in margined trades. This practice will almost always end in ruin, or at least frequent margin calls and necessary action to alleviate them.