SPAN-Ning the Margin Problem for Commodity Options
Mayer, Terry, Modern Trader
SPAN-ning the margin problem for commodity options
* Commodity options are no different than equity options and should be margined in the same fashion. * Commodity options are an extension of a futures contract and should be margined as futures.
That debate has been going on for the six years that exchange-traded commodity options have been available in the United States. The truth, perhaps, is that commodity options are unique instruments and should be dealt with accordingly.
One method that fairly evaluates risk and margins it appropriately is Standard Portfolio Analysis of Risk (SPAN), a system unveiled by the Chicago Mercantile Exchange (CME) in 1988 to margin both futures and options. First called "Dollars at Risk" (DAR), it was renamed to broaden its application to other currencies.
The Coffee, Sugar and Cocoa Exchange (CSCE) Clearing Corp. has implemented SPAN margining for its clearing members, and the CSCE plans to start it at the customer level.
Until now, each exchange/clearing corporation has set its own policies and procedures for margining.
Brokerage firms try to offer customers the best possible service in a cost-efficient manner while adhering to the margining rules of the various exchanges on which they trade. In many cases, this forces brokerage firms to use the most conservative exchange margining rule. As a result, the customer may be overmargined, not only theoretically but actually, depending on the exchange used.
Margin is a very different animal in commodities than in securities. The money posted by the customer with the brokerage firm and by the clearing firm with the exchange/clearing entity is to assure performance under the terms of the contract. In theory, if all participants were capable and willing to perform under any circumstance, no margin would be needed.
Margin in commodities is goodfaith money or a surety bond. Thus, margins should be of such magnitude that they assure each participant of the coverage of potential loss for some period of time.
In most cases, the various exchange margining systems recognize that the risk associated with options can be substantially different than that associated with the underlying futures contracts. As options have become more familiar, exchanges generally have become more lenient in their margin policies.
In the most simple case, a long option is fully paid for: Not only does it have no risk (beyond purchase price), it is an asset that, to some degree, offsets other risks in an account.
However, granted options (or short options), depending on their strike price, may have a risk as great as an outright position in the underlying futures. This risk is tempered as to direction by whether the option is covered or uncovered (naked).
Most commodity option margining systems have two major problems: * Which option gets paired against which futures to create the lowest margin requirement?
The first problem is easy to understand, as this simple example shows:
1 long March cranberry future at 250 1 short May cranberry future at 270 1 long March 250 cranberry put
The actual margin charged on this position will depend on which two positions are paired. One possibility is to pair the futures into a March/May spread, leaving a long March 250 put. In this case, the margin requirement is $750 for the spread and no margin for the long put, hence a total margin requirement of $750.
Or you could pair the long March futures and the long March 250 put, leaving a short May futures position. The long futures position with the at-market put has no risk and requires no margin. The short futures position has no cover and must be fully margined at $1,500.
As the example shows, the margin requirement can be $750 or $1,500, depending on how the positions are paired. It would appear simple to just figure the account both ways and charge the lower requirement. …