This article was originally published in The Option Strategist Newsletter Volume 1, No. 30 on June 25, 1992.
Futures option margin requirements for customers are generally more logical than equity or index option requirements. For example, if one has a conversion or reversal arbitrage in place, his requirement would be nearly zero for futures options, while it could be quite large for equity options. Moreover, futures exchanges have recently introduced a better way of margining futures and futures option portfolios -- the SPAN system (Standard Portfolio ANalysis of Risk). SPAN is designed to determine the entire risk of a portfolio, including all futures and options. It is a unique system in that it bases the option requirements on projected movements in the futures contracts as well as potential changes in implied volatility of the options in one's portfolio. This creates a more realistic measure of the risk than the somewhat arbitrary requirements that were previously used (called the "customer margin" system) or than those used for stock and index options.
Not all futures clearing firms automatically put their customers on SPAN margin. Some use the older customer margin system for most of their option accounts. As a strategist, it would be beneficial to be under SPAN margin. Thus, one should deal with a broker who will grant SPAN margin.
The main advantages of SPAN margin to the strategist are twofold. First, naked option margin requirements are generally less, and second, certain long option requirements are reduced as well. This second point may seem somewhat unusual -- margin on long options? SPAN calculates the amount of a long option's value that is at risk for the current day. Obviously, if there is time remaining until expiration, a call option will still have some value even if the underlying futures trade down the limit. SPAN attempts to calculate this remaining value. If that value is less than the market price of the option, the excess can be applied toward any other requirement in the portfolio! Obviously, in-the-money options would have a greater excess value under this system.
Certain basic requirements are determined by the futures exchange, such as the amount of movement by the futures contract that must be margined (maintenance margin). Once that is known, the exchange's computers generate an array of potential gains and losses for the next day's trading, based on futures movement within a range of prices and based on volatility changes. These results are stored in a "risk array". There is a different risk array generated for each futures contract and each option contract. You, the customer, do not have to make any calculations. The exchange does all the mathematical calculations needed to project the potential gains or losses. The results of those calculations are presented in the risk array, which the clearing member (your broker) uses to generate margin requirements for your specific positions. The following examples show how the items of the risk arrays are combined to generate a SPAN margin requirement. This is to help understand how the system works; in actual practice, the customer never sees the individual items in the risk arrays.
There are 16 items in the risk array: for seven different futures prices, SPAN projects a gain or loss for both increased and decreased volatility -- that makes 14 items -- plus SPAN also projects a profit or loss for an "extreme" upward move and an "extreme" downward move. The futures exchange determines the exact definition of "extreme", as well as defines "increased" or "decreased" volatility. Now let us consider an option example. In this type of calculation, the exchange uses the 16 scenarios and calculates the option theoretical values as they would exist on the next trading day.
Example: Using the S&P 500 futures contract, the following array might depict the risk array for a long December 410 call. One does not need to know the option or futures price in order to use the array -- the exchange incorporates that information into the model used to generate the potential gains and losses.
Scenario: Long 1 S&P 500 December 410 call Potential Pft/Loss Futures unchanged; volatility up +460 Futures unchanged; volatility down -610 Futures up one-third of range; volatility up +2640 Futures up one-third of range; volatility down +1730 Futures down one-third of range; volatility up -1270 Futures down one-third of range; volatility down -2340 Futures up two-thirds of range; volatility up +5210 Futures up two-thirds of range; volatility down +4540 Futures down two-thirds of range; volatility up -2540 Futures down two-thirds of range; volatility down -3430 Futures up three-thirds of range; volatility up +8060 Futures up three-thirds of range; volatility down +7640 Futures down three-thirds of range; volatility up -3380 Futures down three-thirds of range; volatility down -3990 ___________________________________________________________ Futures up "extreme" move +3130 Futures down "extreme" move -1500
The items in the risk array are all quite logical: upward futures movements produce profits and downward futures movements produce losses in the long call position. Moreover, worse results are always obtained by using the lower volatility as opposed to the higher one. In this particular example, the SPAN requirement would be $3990 ("futures down three-thirds; volatility down"). That is, the SPAN system predicts that you could lose $3990 of your call value if futures fell by their entire range and volatility decreased -- a "worst case" scenario. Therefore, that is the amount of margin one is required to keep for this long option position. Note that the exchange does not specifically tell us how much of an increase or decrease they use in terms of volatility.
The real ease of use of the SPAN risk arrays is when it comes to evaluating the risk of a more complicated position, or even a portfolio of options. All one needs to do is to combine the risk array factors for each option or future in the position in order to arrive at the total requirement.
As might be expected, the worst case projection for a covered write is for the stock to drop, but for the implied volatility to increase. The SPAN system projects that this covered writer would lose $6620 if that happened. Thus "futures down 3/3rds of range; volatility up" is the SPAN requirement, $6620.
The advantages of SPAN margin are substantial: one could write many more covered calls under SPAN margin than he could under the older system. As a means of comparison, under the older "customer margin" option requirements, the requirement for a covered write was the futures margin, plus the option premium, less one-half the out-of-the-money amount. In the above example, assume the futures were at 408 and the call was trading at 8. The "customer" covered write margin would then be significantly more than the SPAN requirement:
Futures margin $22,000 Option premium + 4,000 1/2 out-of-money amount - 1,000 $25,000
In actual practice, the SPAN requirements are even more sophisticated: they take into account a certain minimum option margin (for deeply out-of-the-money options); they account for spreads between futures contracts on the same commodity (different expiration months); they add a delivery month charge (if you are holding a position past the first notice day); and they even allow for reduced requirements for related, but different, futures spreads (T-Bills versus T-Bonds, for example).
The procedures for the actual calculation of SPAN requirements are too complicated for the individual clearing member or customer to bother with. However, the risk arrays are available to anyone who wants them. As a private customer, one can buy a simple computer program from the Chicago Mercantile Exchange. This program, called PC-SPAN, makes all the required calculations and prints them out in a fair amount of detail. The program only costs $100. The user inputs his positions into the program and the program does all the rest of the work.
In addition to running the program, one must be able to get the risk array data from the exchange when he wants it. This is easily accomplished since the exchanges have worked out an arrangement with Compuserve to place the risk arrays on that system each night. Then, it is a matter of using the modem on your computer to place a local telephone call (in most cases) to access the risk array data. An additional program, called Intro-Pak, costing $15 is required in order to be able to load the risk arrays from Compuserve. The main cost -- which could become a problem -- arises from the connect time charges to Compuserve: it may cost $5 or so per day to download the risk arrays from each exchange (and each exchange's risk arrays must be downloaded separately onto your computer).
The real advantage to having this program is not so much to calculate the SPAN requirements on your present position (although you may occasionally want to check your broker to make sure he's doing the calculations correctly). Rather, its main use for the strategist is to be able to tell what the margin requirements would be for a new position that is being considered. Without the risk array data, one cannot predict his SPAN margin requirement for a proposed new position, since he does not have a simple formula to rely on as stock or equity option traders do.
This article was originally published in The Option Strategist Newsletter Volume 1, No. 13 on June 25, 1992.