A Primer on Margining Styles for Options

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:

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 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.

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

• 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

  
  
  

• 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