Many of today's stock option traders may not realize that margin rules differ across the various option exchanges. For instance, the Chicago Board Options Exchange (CBOE) has a margin system different from that used by the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). The latter two use a system known as standardized portfolio analysis of risk or SPAN, the world's leading margin system, adopted by most options and futures exchanges around the world. It is based on a sophisticated set of algorithms that determine margin according to a global (total portfolio) assessment of the one-day risk of a trader's account.

Let's look at the general idea behind margin and what SPAN futures and option margin are. SPAN provides futures and commodity option strategists with a key advantage: more bang for their margin buck!

What Is Options Margin?
Option margin, very simply, is the money that a trader must deposit into his or her trading account in order to trade options. This is not the same as margining stock. Margin for stocks is actually a loan to you from your broker so that you can buy more stock with less available capital. Margin for options on futures is a performance bond deposit that earns interest because it is usually held in the form of short-term Treasury bills.

For example, to write a simple bear call spread on the S&P 500, you would need to have sufficient margin (a "good-faith" performance bond) in your account to open the position. Buying options outright typically does not require any deposit of margin because the maximum risk is what you pay for the option.

For our purposes, margin is what the broker requires you to have in your account if you want to implement an option writing strategy. For a typical "one-lot" (i.e. simple 1 x 1) credit-spread position, margin, 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 is that the ratio of margin to net premium collected should be 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.

One additional point about option margin is that it is not fixed. In other words, initial margin is the amount required to open a position, but that amount changes every day with the market. It can go up or down depending on changes in the underlying, time to expiration and levels of volatility. SPAN margin, which is the margin system developed by the Chicago Mercantile Exchange (CME) and used by all traders of options on futures, can help explain how this movement works. SPAN margin is considered by many to be the superior margin system available.

The SPAN System
For option writers, SPAN margin requirements for futures options offer a more logical and advantageous system than ones used by equity option exchanges. 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 to other positions (new or existing) requiring margin.

Futures exchanges predetermine the amount of margin required for trading a futures contract, which is based on daily limit prices set by the exchanges. The predetermined amount of margin required allows the exchange to know what a "worst-case" one-day move might be for any open futures position (long or short).

Risk analysis is also done for up and down changes in volatility, and these risks are built into what are known as risk arrays. Based on these variables, a risk array is created for each futures option strike price and futures contract. A worst-case risk array for a short call, for example, would be futures limit (extreme move up) and volatility up. Obviously, a short call will suffer from losses from an extreme (limit) move up of the underlying futures and a rise in volatility. SPAN margin requirements are determined by a calculation of possible of losses. The uniqueness of SPAN is that, when establishing margin requirements, it takes into account the entire portfolio, not just the last trade.

The Key Advantage of SPAN
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 marginable instruments. These T-bills, however, do get a "hair cut" (a $25,000 T-bill is marginable 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 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. Net option sellers can often receive favorable treatment. Here's 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 with an offsetting delta factor (i.e. the call spread is net short 0.06 and the put spread is net long 0.06), 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, and a non-neutral gamma will change the delta factors. 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 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 does not get this favorable treatment when operating with the same strategy.

The Bottom Line
While there are other types of trades that would illustrate the advantages of SPAN, the covered short strangle example shows why index and equity option writers remain at a competitive disadvantage. (See An Option Strategy for Trading Market Bottoms for another example of more favorable treatment by SPAN.)


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