The SPAN margin system used in futures can not only provide high returns on invested capital, it encourages responsible risk management
By James Cordier, Michael Gross, Portfolio Managers, Liberty Trading Group/OptionSellers.com
When I was a young man in college, three of my friends and I decided we wanted to rent a house off of campus for our junior year. Wanting to secure the lease before we went home for summer break, we scheduled a time to meet with our future landlord. When we arrived, a robust looking bearded man greeted us and took us into a dark paneled living room to discuss his proposal. After a brief exchange of small talk, Joe, which was the only name he gave us, got down to business.
“$1800 a semester,” he stated, “plus a $900 security deposit.”
We all nodded in agreement and after a few general questions, agreed to lease Joe’s property. We all agreed to meet again in a week to sign the lease and give him our security deposit. We did not know the dismay that awaited us at our next meeting.
The “deposit” we were asked to put down, was a good faith money that was put up in order for Joe to hold while we lived in his house. If there was any damage to the house when we left, Joe could deduct the repair costs for these damages from our deposit.
When selling an option, we put up a deposit just like this. Except, in futures options trading, instead of a security deposit, these funds are called margin or the margin requirement.
Novice futures traders or traders familiar only with equities often misunderstand the term margin as it applies to futures trading. For stock traders, the term can be particularly misleading, as margin in equities trading has quite a different meaning than margin in a futures option account. In stocks, talk of margin is most often associated with borrowing money from the brokerage house to trade stocks or stock options, thereby increasing ones leverage. Futures options are already leveraged. The term margin has a completely different meaning. Margin in futures options is simply a deposit of one’s own funds he puts up in order to hold a short option. Like a security deposit, the margin is on account to cover any potential losses (damages) to the position. Therefore, since one is not buying anything and there is no cost to entering the position, he must put up some funds in order to cover any potential loss on the trade.
Similar to when a futures position is established, when a trader sells options, there is a margin requirement. This is the amount of money that is required to hold the position. Margin requirement for selling futures options is determined by the individual exchanges.
The exchanges have developed what is known as a SPAN system. The system was designed exclusively for selling options on futures contracts. The SPAN system determines margin requirements for specific options. SPAN margins are based on a variety of factors such as historical and implied volatility of the underlying futures contract, distance that the strike price is from the money, time remaining on the option and current value of the option. SPAN is the exchange’s way of calculating risk and trying to determine the probabilities of the option ever going in the money and/or increasing in value. With the SPAN system, margins on short options are almost always less than the margin for the underlying contract.
Individual clearing firms are not required to use SPAN in determining margins for options. It is for this reason that some clearing firms simply charge full futures margin to traders selling options. However, firms friendly to option writing will generally operate under the SPAN system.
SPANS, however, can and do fluctuate. Which brings us back to our story.
A week after our initial meeting with Joe, my new housemates and I returned to Joe’s house with our rental deposit. What happened next ruined our day.
Joe had changed the deal.
“I’m sorry guys but I’ve thought it over” he explained, “and I have to raise the deposit.”
Joe now wanted $1800 as his security deposit.
He gave us a long explanation about “protecting his investment” et, little of which made any sense to us at the time. We left dejected, and told him we would think it over.
What we did not know was that Joe had just had a bad experience with some tenants in another one of his houses. They had left the house in bad condition and their security deposit would not cover all of the repairs that needed to be done. The experience had left Joe with a bad taste in his mouth. In his mind, the risk of renting to college students had gone up. Therefore, he had to bring his security deposit up to match his perceived risk.
If you understand this concept, you now understand how the exchanges set SPAN margin. The SPAN (Standardized Portfolio Analysis of risk) system was developed in order to match the theoretical risk of a position with the capital required to hold it. As we know, selling naked futures options can entail unlimited risk – a fact that brokers unfriendly to option selling are not shy about pointing out to clients – repeatedly.
Yet, despite the ominous sounding term, “unlimited risk” simply means that there is no built-in device to manage your risk and cut your losses. You have to do it yourself, just like you would with a futures or equity position. You have to close out the position when it reaches your risk parameter or place a stop to do it for you (many options contracts accept stop-loss orders). Therefore selling an option on a futures contract or stock carries no more risk than trading the underlying itself. In fact, in most cases, the risk is less because the options are out of the money (away from the underlying contract’s price).
The exchanges realize this and this is why the margin for holding a short option is typically less than that to hold the underlying futures contract. Like Joe, the exchanges set the margin requirement in order to match perceived risk.
This is why options with higher premiums or in markets with larger contracts typically require higher margins than those in smaller markets or with smaller premiums.
Unlike Joe, however, the exchanges reevaluate risk at the close of business each day. This is why margin requirements for short options can vary from day to day. While fluctuations in margin requirements are typically mild, they will fluctuate based on daily market movement, volatility, distance from the money, and changes in the fixed margin requirement for the underlying futures contract.
This brings us to another aspect of risk management. If the market is moving against your position, the value of your option can increase even if the option has not gone in the money. This can happen relatively quickly, relatively slowly, or not at all depending on how close to the money the option is and how much time is left on the option. As a general rule, options sold very close to the money will increase in value faster than options sold far out of the money, even if the far out of the money options have more time value left.
When the value of the option increases, so does the margin. The margin requirement will increase at least in proportion to the option’s value.
For example, a trader is neutral/bullish soybeans and sells a $10.00 September Soybean put. He collects a $600 premium and puts up $1500 in margin (these are theoretical values for the purpose of the example). Thus, while the premium collected will cover $600 of the margin requirement, he has to put up $900 of his own money to hold the position. As long as soybeans are anywhere above $10.00 per bushel at expiration, the option will expire worthless and the trader will keep all premium he collected as profit. However, if soybean prices begin to fall, the value of the option can increase.
Let’s suppose after the trader writes the 10.00 put, the price of soybeans begins to decline. Three weeks later, the 10.00 put option that he sold for $600 is now worth $800. It has increased by $200. Therefore, his margin will have increased by $200. He now has to have $1100 of his own money in the trade to hold the position. This can happen without the option ever reaching the 10.00 strike price.
On the other hand, should soybean prices begin to climb, the value of the put option would most likely decrease. Thus, the margin requirement would typically decrease as well. Traders believing that they must wait until the position closes or expires to get their margin funds back are mistaken. Margin can go back into ones available funds as the margin requirement on existing positions decreases.
Regardless of margin fluctuation, if the strike price is not reached, the option will sooner or later fall prey to it’s own time value and begin to deteriorate and eventually, expire worthless.
Maximizing Potential Profits using SPAN
The fact that collected premium can be used to help meet margin requirement increases potential return on invested funds dramatically. Considering the leverage already built into futures options, ROI on an short futures option position that expires worthless can be as high as 60,70 even 80%. It can be an attractive proposition, as long as one is comfortable with the fact that potential losses to the deposit can be proportional to the potential gains, and possibly greater.
In most cases, unless a trader is writing options very close to the money, he will not have to worry about his option values or margins increasing as quickly as say, a futures contract. Selling far out of the money options usually allows for plenty of room for the market to move against one’s short option position.
Nonetheless, traders are always looking for more. Higher profits, lower risk. For such traders, as we have in past articles, we continue to recommend the credit spread as a primary strategy for today’s market conditions. We have discussed credit spreads in the past as a way of controlling or even limiting risk. However, this lesson recommends spreads as a way of increasing ROI. And that means reducing margin without substantially compromising premium.
To demonstrate this, suppose in the previous example, the trader sold the 10.00 soybean put naked and collected a $600 premium. The margin requirement (out of pocket) to hold that option at the time was about $900. Therefore, not including transaction costs, the return on capital invested would be roughly 66% if the trade is successful.
Suppose then that the trader instead took $150 of the $600 premium he collected and bought a 9.00 put. This effectively hedges his position and limits his risk. These two trades together, (buying the further out strike and selling the nearer strike) is called a credit spread. The difference in premium between the two ($450) is called the credit. This becomes the sellers profit if both options expire worthless.
By writing the spread, some traders may believe they are “sacrificing” premium or somehow accepting less in order to buy protection. Yet, by buying the protective put, the trader converts his position from one of unlimited risk to finite risk. Therefore, the exchange lowers the margin substantially for these types of positions. If a trader would have entered the Sept 08 10.00/9.00 bull put spread this month and filled at the premiums previously listed, the margin on the spread was approximately $550. If the options expire worthless, that’s an 81% return on capital before transaction costs – in what is ultimately a safer trade than selling naked.
The SPAN margin system in futures options is one of the primary differences between stock and futures options. It is also the key to the high returns possible in selling futures options – for those comfortable with the leverage. Traders can lower margins further and increase ROI in some cases by selling credit spreads.
Joe didn’t give us the choice of lowering our deposit requirement and we therefore ended up paying him his $1800. In case you’re wondering, we did get it back at the end of the year, just like a successful option sale.
To learn the full strategy of selling options, spreading and risk management, we recommend reading The Complete Guide to Option Selling by James Cordier and Michael Gross (McGraw-Hill 2005).
If you have an interest in option selling or building a portfolio based on this strategy, feel free to visit us on the web at www.OptionSellers.com and request a free investor information pack (recommended for accredited investors only.)
Liberty Trading Group
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, the first futures firm in the US to specialize exclusively in selling options. James’ market comments are featured by several international financial publications and worldwide news services including The Wall Street Journal, Yahoo Finance, CNBC and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.