Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Visit Garner at www.DeCarleyTrading.com. Her books, Commodity Options and A Trader’s First Book On Commodities, are available from FT Press.
WHAT DO I DO IF I GET A MARGIN CALL? (part 2)
Last time, we discussed the mechanics of a margin call, about how they are triggered and how position delta can be used to manipulate margin. This time, we’ll focus on the margin process and a hands-on example of making adjustments to margin and risk.
Margining short options: Before we can consider margin adjustment, we need to understand the basics of short option margining. What many people don’t realize is selling an option immediately increases the cash in a trading account in the amount of premium collected minus transaction costs.
Although the short option itself is a liability, the cash collected enhances the equity that the margin is measured against. Accordingly, each dollar collected in premium increases the marginable funds. That said, option selling isn’t a risk-free printing press for money; short option premium acts as a cushion toward losses at expiration but also leaves the trader open for theoretically unlimited risk of loss.
Margining long options: Long options involve limited risk when used as a speculative tool and therefore are not margined. As long as your trading account has enough money to purchase the option, there is no additional funding requirement. However, long options are also a form of insurance and can be used to reduce the risk and margin of an open-ended position such as a futures contract or a short option. That said, don’t forget the cash used to purchase options is no longer available to use toward margin. In addition, because options are an eroding asset, they are not accepted as a means of meeting margin.
Margin adjustment: Last time, we mentioned the key to margin adjustment is being aware of position delta and the impact of purchasing and selling instruments to manipulate its value. The delta of the position is simply the pace at which the overall position changes value relative to the underlying futures contract. A futures contract has a delta of 1 because for every point it moves, the trader is making or losing one point.
Assuming the margin charged by the Chicago Mercantile Exchange (Cme) for its yen futures contract is $5,400, a trader purchasing a single yen futures faces an initial margin requirement of $5,400 and a maintenance margin requirement of $4,000. This means that the trader is able to hold a position overnight (beyond the close of trade) as long as at least $5,400 is on deposit.
If the account value drops below $4,000 based on daily closing values, the trader will be issued a margin call. If this happens, the trader might choose to add $1,400 to the account to meet the call or he can adjust his margin and risk.
Using hypothetical market values, somebody who is short the yen in late June 2010 might have been able to purchase July call 100 points out of the money for about $600 or 38 ticks. Doing so is not cheap, but it does create a limited-risk scenario in which the trader is only exposed to risk in the amount of the option price plus the difference between the futures entry and the strike price of the call. The call purchase also reduces the initial margin requirement to $2,957, which is well below the $4,000 currently on deposit. Better yet, the maintenance (as opposed to initial) margin requirement would likely be closer to $2,000, and this mitigates the risk of the trader undergoing another margin shortage.
Unfortunately, options don’t last forever. Similar to the purchase of car insurance in which coverage is only provided for a specified period, options expire, and this immediately removes their protective benefits and margin breaks.
The same trader could have opted to sell a put to bring in cash to counteract the margin call as well as reduce the initial margin required to hold the trade. The sale of an August option approximately 200 points beneath the market might have brought in $1,100. The money collected goes toward paying down margin in the account. Not only that, assuming that the newly sold put had a delta of 30% implies that the position volatility would be reduced by the same amount; the trader would have reduced his delta from 1 to 0.70 (1 – 0.30) and in turn would have likely reduced the margin required by about the same amount. Thus, the new margin requirement would likely be under $4,000; along with the $1,100 in cash collected, that would have been more than enough to alleviate the trader’s margin problem. It would have also reduced the profit potential on the trade immensely. This trader stands to make the premium collected plus any difference between the entry price of the futures and the strike price of the option.
It would have also been possible for this trader to take both actions; being short a futures contract, long a call option and short a put option is known as a collar. A collar involves limited risk and limited profit potential and can be a great way of reducing market volatility. The downside of this strategy is limited profit potential.
If you are interested in a deeper look into this subject, look for my mini ebook Adjusting Margin And Risk, published by FT Press.