How To Margin Commodity Options
How to margin commodity options is the follow-up to our popular commodity futures margin tutorial. When you read this mini-course on how to margin commodity options, you'll find it to be an easy read in commodity option margins, with a glossary of terms and a step by step guide. We'll explain how and why a commodity option margin call is created and subsequently disposed of. But first, let's get you up to speed with…
A "Quick and Dirty" Commodity Options Glossary
Commodity Options Contract - An option contract for the right, but not the obligation to buy or sell an underlying commodity futures contract at a specific price on a future date.
Call Option - The buyer of a call option has the right to take a long position in the underlying futures contract at a specific price.
Put Option - The buyer of a put has the right to take a short position in the underlying futures contract at a specific price.
Option Premium - The value of an option contract. It's composed of the intrinsic value if the option is in the money and the time value.
Intrinsic Value - Only in the money options have intrinsic value. It's the difference between the strike price and the underlying futures price.
Time Value - A market sensitive value placed on an option contract based on the time distance to the options expiration date. As the option nears expiration, the time value diminishes.
Strike/Exercise Price - The set price at which the option may be exercised into the underlying futures contract. The strike price also determines the in or out of the money amount of the option. Strike prices are set at the time the contract originates
In the Money - For call options, when the strike price is below the underlying futures price, it's in the money. For put options, when the strike price is above the underlying futures price, it's in the money.
Out of the Money - For call options, when the strike price is above the underlying futures price, it's out of the money. For puts, when the strike price is below the underlying futures price, it's out of the money.
SPAN Margin - SPAN stands for Standardized Portfolio Analysis of Risk. Originally developed by the CME, SPAN is used almost universally at commodity exchanges around the world in the process of establishing option margin requirements. SPAN uses algorithms to help determine option margin requirements using a global assessment of one-day volatility and risk.
Initial/Original Margin Requirement - The funds required in a commodity account when a position either long (bought) or sold (short) is established.
Variation/Maintenance Margin Requirement - The equity point at which a margin call is issued to bring the account back to the initial/original margin level.
Initial/Original Margin Call - A margin call that is issued when a new position is taken.
Variation/Maintenance Margin Call - A margin call requiring enough funds to bring the account back to its original margin level.
CBOT - Chicago Board of Trade - Domestic commodity futures/options exchange.
Equity - The account net worth which equals the funds deposited plus the unrealized gains or losses on commodity contracts (positions) in the account at any given time.
Settlement/Closing Price - The daily price that is set at the end of every trading day. This price is used as the basis for determining account equity.
Point Value - The dollar value for each 1 point move in the contract price. For T-Bond futures it's 1/32nd or $31.25. For T-Bond options, it's 1/64th or $15.63.
T-Bond Contract - CBOT contract for a $100,000 T-Bond. Point value is $31.25 per tick and one full point equals 32/32nds or $1000. Initial Margin: $2700 Maintenance Margin: $2000. (Margin requirement is for educational purposes and can change at any time.)
T-Bond Option Contract - CBOT option contract for the underlying CBOT T-Bond futures. The option contract's size is identical to the underlying futures contract, but the point or *tick* value is different. The point value for T-Bond options is 1/64, whereas futures are 1/32. One full point equals 64/64ths or $1000. There are no limits to the price fluctuations in option contracts.
T-Bond Short Option Margin Requirement - Collect the premium in full. Maintain the greater of the outright futures margin minus ½ the amount that the option is out of the money or ½ the futures margin plus the option premium on a mark to market basis. In the money options require the original futures margin plus the premium on a mark to market basis.
Commodity Futures Price Ticker
Check daily commodity futures prices with this commodity futures price ticker located on the right side of this page. Courtesy of thefinancials.com
Commodity Options Margin Tutorial
Let's establish a hypothetical commodity options position
In an effort to keep both the option and futures margin tutorials somewhat consistent, we will use the CBOT T-Bond contract in our example. In addition, because an option purchase whether it be a put or a call, only requires the payment of the premium and no margin, we will establish our hypothetical option position as a short sale of a call option.
This type of position is also known as a naked short. Remember, the market information in this example is fictitious and only stated for our learning environment. Let's get on with it…
It's January 3rd, 2005, the Fed just raised interest rates and feels the robust economy might warrant further increases to avoid possible inflation. You feel the information is likely to result in continued rising interest rates and a sharp drop in T-Bond prices.
You quickly establish a position in the CBOT T-Bond option market and sell two March T-Bond 9500 call option contracts at a price of 1-32, which is equal to 96/64ths. Your goal is to sell the call option contracts, collect the premium and hope the price of the underlying futures declines.
If you're right, this erodes the option premium value to a point at which you can buy the short option back, liquidating your position at a lower price and profit from the difference. The settlement price for the underlying March T-bond futures price at the end of the day is 9510. The option premium settlement price is 1-24 or 88/64ths.
Whoa Nelly…What do all those numbers mean?...Let's analyze it. For starters, the option is in the money because the strike price is 9500 and below the underlying futures settlement price of 9510. The option contracts have an intrinsic value of $312.50 each based on the futures settlement price. The premium received is equal to $1500 per contract. That's based on the option trade price of 1-32 or 96/64ths. The $1500 premium is a combination of the in the money amount, $312.50 and the time value of the option, $1187.50. Out of the money options only have Time Value.
Side Note: The calculations for this option margin requirement example can only be an estimate until the SPAN margin arrays are factored in to the final number. Without the application of SPAN, an option margin requirement is not conclusive, it's only an estimate.
The following day you have an initial margin call
Based on the settlement price of 9510 your call option contract is in the money. You have total equity in the account of $3000. That's the premium you received by shorting 2 options contracts at $1500 each. The calculation looks like this:
96 X $15.63 = $1500 X 2 contracts = $3000. Your margin requirement is $8150. It's based on the T-Bond option settlement price of 1-24 and the underlying futures margin of $2700 per contract. The margin requirement for naked short in the money options is the full futures margin plus the premium on a mark to market basis. The calculation looks like this:
$2700 X 2 = $5400 + $1375 X 2 = 2750…$5400 + $2750 = $8150 Initial Margin.
Your broker calls you and issues you an initial margin call of $5400. $5400 is derived from your position of 2 T-bond option contracts with an initial margin requirement of $2700 per contract. Your total margin requirement is $8150, but you received $3000 from the short sale of the naked options, putting your equity at $3000.
The calculation looks like this: $2700 X 2 = $5400. You wire transfer the funds the same day and your account has a total equity of $8400. That equals the initial margin deposit of $5400 + $3000 premium received by shorting the 2 call options. You have an excess on the trade of $250. The calculation looks like this:
$8150 margin requirement - $8400 total equity = $250 excess.
On the same day the commerce department issues the new unemployment figures which show a huge rise in the unemployment rate from 4.2 to 4.8. The bond market rallies higher and the price for your March T-Bond 9500 call options settles at 2-00 or 128/64ths, rising 40/64ths on the day. The underlying March T-Bond futures contract settles at 9600, up 22/32nds. With the wired funds in the account, your total equity remains $8400, but your margin requirement will change tomorrow. Let's see why…
The following day you receive an initial margin call
The change in the settlement price of the T-Bond options has increased your margin requirement to $9400. Because your options are still in the money, your new margin requirement is derived from the underlying futures margin requirement of $2700 per contract plus the option premium on a mark to market basis. The option settlement price of 2-00 is equal to $2000 or 128/64ths per contract. The calculation looks like this:
$2700 X 2 = $5400 + $2000 X 2 = $4000…….$5400 + $4000 = $9400.
You are issued a margin call of $1000 because your total equity is still $8400, but you're your margin requirement has increased to $9400. The calculation looks like this:
$8400 total equity less margin requirement of $9400 = <$1000>. You wire transfer the $1000 to your account to meet your margin call the same day and because of a bullish GNP forecast, the March T-Bond contract tanks and closes at 9416, down 1-16. Your March T-Bond options contracts settle at the price of 1-10, down 54/64ths.
The next day…Now you can take some money off the table
A very important thing happened to the characteristics of your call options at the close of business yesterday. Do you know what it is?
The 9416 settlement price of the March futures means that your call options are now out of the money instead of in the money. That means that at the close of business yesterday your options no longer have Intrinsic Value. They only have Time Value. Secondly, the calculation for your margin requirement changes because the options are no longer in the money.
The margin requirement for naked short out of the money call options is as follows: The futures margin less fifty percent of the amount by which the option is out of the money, plus the premium on a mark to market basis.
Your total account equity is $9400 your margin requirement has fallen to $7212.50. You have an excess in your account of $2187.50. How?....Let's look at the calculation: First, the options are out of the money by $500. Because they are now out of the money, ½ of that amount reduces the underlying futures portion of your margin requirement by $250 per contract. You have 2 option contracts, so the total reduction from the underlying futures margin is $500.
The underlying futures portion of your margin requirement has fallen to $4900. The calculation looks like this: $5400 - 500 = $4900. In addition, the portion of your margin requirement related to the option premium has also changed.
Your option premium has also fallen to $1156.25 per contract. Remembering that a portion of your margin requirement is the option premium on a mark to market basis, the lower option premium means a lower margin requirement. In this case you have 2 contracts with a premium of $1156.25 each, your premium portion of the margin requirement is now $2312.50. The calculation looks like this:
$1156.25 X 2 = $2312.50. Your new margin requirement is $7212.50, which is the total of the underlying futures portion of $4900, plus the option premium portion of $2312.50. The calculation looks like this: $4900 + $2312.50 = $7212.50. With your margin requirement at $7212.50 and your total equity at $9400, you have an excess in your account. You can request the excess funds to be sent back to your bank account. This is called a payout. The calculation looks like this: $7212.50 - $9400 = $2187.50
That's all there is to it. Each day your position is recalculated based on the settlement price and your margin requirement. Your equity is determined and your margin call or payout is calculated.
How can you satisfy option margin calls
There are a number of ways to meet margin calls. Everybody knows you can add funds to your account, but you can also put T-Bills into your account as collateral or liquidate positions which will reduce your margin requirements.
In addition, sellers of naked short options receive the option premium from the buyer. The funds received from the option premium can also be used to purchase T-Bills to margin the account.
That's it. Now you have a basic blueprint on how to margin commodity options. It gets a little more complicated with multiple commodities, spread positions and multiple exchanges, but this will take the mystery out of where all that money goes on a daily basis.
By: Rick Contrata
Rick has been in the commodity industry for almost
25 years, holding management and executive positions
In commodity operations and margins with
ACLI, Bear Stearns and DLJ. He also owns an
Internet marketing, consulting and copywriting business.
Commodity Hedging, Hedging Risk with a Commodity Hedging Strategy
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