A Primer on Margining Styles for Options

  • 23 Oct 2015
  • By CME Group
  • Topics: Energy

This document gives an overview of the differences between the margining of equity-style and futures-style option contracts. In derivatives trading, margin refers to the good faith deposit, or collateral, required to be deposited by an option writer. Margining is the entire process of measuring, calculating and administering the collateral that must be put up for coverage of open positions.

Exactly as with equity-style options, the underlying of a deliverable futures-style option could be a futures contract, or a combination of futures contracts such as a calendar spread, an inter-commodity spread, or a stripInitial margin, also known as the total performance bond, is the term applied to the initial deposit or margin money each customer is required to put up as security for a guarantee of contract fulfillment at the time a futures or option position is established. Initial margin requirement has two components: the risk component and the equity component. The risk component is the risk level determined by SPAN (“Standard Portfolio Analysis of Risk”), which is a market simulation-based Value at Risk system. The equity component is the net option value, which will be discussed in the following section. The margin rates used for calculating initial margin requirements for CME Group’s futures and options products are available online.  The requirement amounts for specific portfolios are calculated using SPAN. Variation margin is the payment made on a daily or intraday basis by a clearing member based on price movement in positions carried by the customer.

Equity-style Margin

In equity-style margining, also known as “traditional” or “premium-paid-upfront” margining, the premium is paid in full at the time of the option purchase. Because the premium is immediately paid, the current market value of the option becomes a credit (if net long) or debit (if net short) to the margin requirement. The premium is calculated at the original trade price and is recognized on the day the trade clears. Thereafter, as long as the trade remains open, the current market value of the option is taken into account in determining the total initial margin requirement.

In traditional equity-style margining, the writer of the option can gain interest income with the re-investment of the initial premium. Therefore, the seller generally demands a lower option premium for an equity-style margin option compared to a futures-style margin option, which will be discussed later.

The concept of Net Option (or Liquidation) Value (NOV) is important when equity-style options are discussed. NOV allows the buyer to offset any other obligations and enables the Exchange to close out a position in case of default. More specifically:

Net Option Value = Option Price x Contract Size x Position Quantity

When a buyer purchases an option, they receive an NOV credit, which can be used as collateral against other obligations such as initial margin requirements and debit NOV on other option positions. When a seller sells an option, they pay debit NOV, which must be covered by cash or collateral in the same manner as the original margin. 

Futures-style Margin

Futures-style margin options behave in a manner somewhat analogous to that of a futures contract. The trade of the option itself does not result in any cash flow as the premium does not immediately move.  Rather, every open position is marked to market and the resulting settlement variation (or variation margin) amounts are netted together with other such amounts in determining the net pay/collect amount. The total premium of a futures-style option is calculated and paid only on the day the option position is removed, whether by exercise, assignment, or expiration without exercise or assignment. When exercise or expiration of the option contract occurs, the buyer makes a premium settlement payment.

Unlike equity-style margin options, futures-style options have daily realized variation margins calculated. So, margins are paid daily according to the changing value of the option. Also, due to the fact that interest rates do not factor into futures-style margin options, their price differs from equity-style margin options. This is most apparent in long-dated options where interest rates have more time to change option values.

Traditional (Equity-style) Margining Example

Day 1: Trade Date

  • Buyer buys an option and pays option premium to the seller through CME
    Buyer receives NOV credit
    Buyer’s initial margin is zero because the risk requirement is completely offset by NOV

  • Seller sells an option and receives option premium from the buyer through CME
    Seller’s initial margin requirement is the sum of risk requirement and the short NOV

Day 2: Option Price Changes

  • NOV will be re-calculated to account for change in the price of the option. Increases in margin requirements will need to be paid by the buyer or the seller (depending on the price change direction of the option) and decreases in margin will be credited to the buyer or seller’s account
  • If the option price has risen, the buyer’s NOV credit will rise in tandem, which will in turn decrease the margin requirement. The buyer’s account will be credited. As a result of the option price increase, the seller’s NOV debit will increase and additional funds or collateral will need to be sent to the Exchange
  • If the option price has decreased, the buyer’s NOV credit will decrease in tandem, which will in turn increase the margin requirement. Additional funds or collateral will need to be sent to the Exchange. As a result of the option price decrease, the seller’s NOV debit will decrease and the account will be debited

Expiration and/or Exercise Day

  • The buyer may choose to exercise the option if it is in-the-money and receive a position in the underlying futures contract at the strike price
  • Both the buyer and the seller will pay initial margin on the resulting futures position
  • The NOV in both the buyer and the seller’s accounts will become the variation margin on the underlying futures position. Credit NOV in the buyer’s account and debit NOV in the seller’s account will be zero as the option has expired

Equity-style vs. Futures-style Margining Example

  • Suppose on Day 1, the following option transactions occur:

    Dec-2015 Call @ 2.00

     

    Margin Style

    Transaction

    Price

    Lot

    Contract Size

    Option A

    Equity

    Buy

    $2.00

    1

    1000 barrels

    Option B

    Futures

    Buy

    $2.00

    1

    1000 barrels



  • NOV is calculated at the time of transaction as well as the end of the day (based on settlement price) on Day 1.

    Calculation of NOV

    Day 1: Transaction Time

    Option Price

    Buyer Credit

    Seller Debit

    Option A

    $2.00

    0

    0

    Option B

    $2.00

    n/a

    n/a

    Day 1: Day-end

         

    Option A

    $2.25

    $2250

    ($2250)

    Option B

    $2.25

    n/a

    n/a


    Calculation of Margin

    Day 1: Day-end

     

     

     

     

     

    Buyer

    Seller

    Option A

    Debit

    Credit

    Debit

    Credit

        Premium

    ($2000)

    $0

    $0

    $2000

        Variation

    $0

    $0

    $0

    $0

        Total Variation Margin

    ($2,000)

    $2,000

        NOV

    $0

    $2250

    ($2250)

    $0

        Initial Margin

    ($1000)

    $0

    ($1000)

    $0

        Total Initial Margin

    $1250

    ($3250)

    Option B

    Debit

    Credit

    Debit

    Credit

        Premium

    $0

    $0

    $0

    $0

        Variation

    $0

    $250

    ($250)

    $0

        Total Variation Margin

    $250

    ($250)

        NOV

    $0

    $0

    $0

    $0

        Initial Margin

    ($1000)

    $0

    ($1000)

    $0

        Total Initial Margin

    ($1000)

    ($1000)



  • Suppose on mid-day Day 2, the price of the option rises to $2.50:

    Calculation of NOV

    Day 2: Mid-day

    Option Price

    Buyer Credit

    Seller Debit

    Option A

    $2.50

    $2500

    ($2500)

    Option B

    $2.50

    n/a

    n/a


    Calculation of Margin

    Day 2: Mid-day

     

    Buyer

    Seller

    Option A

    Debit

    Credit

    Debit

    Credit

        Premium

    $0

    $0

    $0

    $0

        Variation

    $0

    $0

    $0

    $0

        Total Variation Margin

    $0

    $0

        NOV

    $0

    $2500

    ($2500)

    $0

        Initial Margin

    ($1000)

    $0

    ($1000)

    $0

        Total Initial Margin

    $1500

    ($3500)

    Option B

    Debit

    Credit

    Debit

    Credit

        Premium

    $0

    $0

    $0

    $0

        Variation

    $0

    $250

    ($250)

    $0

        Total Variation Margin

    $250

    ($250)

        NOV

    $0

    $0

    $0

    $0

        Initial Margin

    ($1000)

    $0

    ($1000)

    $0

        Total Initial Margin

    ($1000)

    ($1000)



  • Suppose at the end of Day 2 the buyer exercises the option at $2.75:

    Calculation of NOV

    Day 2: Post-expiration

    Option Price

    Buyer Credit

    Seller Debit

    Option A

    $2.75

    0

    0

    Option B

    $2.75

    n/a

    n/a


    Calculation of Margin

    Day 2: Post-expiration

     

    Buyer

    Seller

    Option A

    Debit

    Credit

    Debit

    Credit

        Premium

    $0

    $0

    $0

    $0

        Variation

    $0

    $0

    $0

    $0

        Option Exercise

    $0

    $2,750

    ($2750)

    $0

        Total Variation Margin

    $2,750

    ($2750)

        NOV

    $0

    $0

    $0

    $0

        Initial Margin

    $0

    $0

    $0

    $0

        Total Initial Margin

    $0

    $0

    Option B

    Debit

    Credit

    Debit

    Credit

        Premium

    ($2750)

    $0

    $0

    $2750

        Variation

    $0

    $250

    ($250)

    $0

        Option Exercise

    $0

    $2,750

    ($2750)

    $0

        Total Variation Margin

    $250

    ($250)

        NOV

    $0

    $0

    $0

    $0

        Initial Margin

    $0

    $0

    $0

    $0

        Total Initial Margin

    $0

    $0



Final points to note:

  • Exactly as with equity-style options, futures-style options may be American (exercise at any time) or European (exercise only at expiration) 
  • Exactly as with equity-style options, futures-style options may be cash-settled or physically-deliverable. If physically-deliverable, when exercised or assigned, the option transforms into a position in its underlying future, and if cash-settled, the mark-to-market from strike price to marking price of the underlying future becomes a cash-flow that is settled together with the option 
  • Exactly as with equity-style options, the underlying of a deliverable futures-style option could be a futures contract, or a combination of futures contracts such as a calendar spread, an inter-commodity spread, or a strip

About CME Group

As the world's leading and most diverse derivatives marketplace, CME Group is where the world comes to manage risk. Comprised of four exchanges - CME, CBOT, NYMEX and COMEX - we offer the widest range of global benchmark products across all major asset classes, helping businesses everywhere mitigate the myriad of risks they face in today's uncertain global economy.

Follow us for global economic and financial news.

CME Group on Twitter

CME Group on Facebook

CME Group on LinkedIn