08 January 2007

Margin Hysteria Rules

Many folks are all a-flutter over the new Margin rules that set to be introduced this April. Most of the hype seems to centred around the leverage available under new rules.

Hitherto unavailable leverage IS available on a some strategies, most notably, buy/writes. But the most amusing thing is ersatz experts waxing lyrical about this amaaaaaaazing leverage now available on such things as married puts and collars.

This really ignores simple synthetic relationships between strategies. Possibly intentionally.

For instance, I read one post on a bulletin board from an allegedly ex-market maker, extolling the virtues of the new leverage married puts will have. Well excuse me, but a married put is just a blinkin' synthetic call! The leverage has been available all along!

It has gotten the stage where folks are predicting either 1/ a leveraged, LCTM style perfect storm, taking out the whole market, or 2/ an incredible bullish flourish as all and sundry massively add to their portfolios, courtesy of this "new" leverage.

I'm predicting business as usual with some small scale stupidty around the edges, just like normal LOL

04 January 2007

New Margin Rules For Option Positions

This was released in the middle of last month, and while trumpeted by a few option education firms, seems to have slipped by largely unnoticed by a lot of the retail trading community.


CHICAGO, December 13, 2006 - The Chicago Board Options Exchange (CBOE) announced today that the Securities and Exchange Commission (SEC) approved amendments to CBOE rules that allow for expanded portfolio margining for customer accounts.The effective date of the amendments is April 2, 2007.

Today's action expands the scope of products eligible for portfolio margining to include equities, equity options, narrow-based index options, certain security futures products (such as single stock futures), and unlisted derivatives. The SEC approved portfolio margining for broad-based index options in July 2005.U.S. futures markets and most European and Asian exchanges for many years have employed risk-based margining similar to CBOE's new rules.

The new portfolio margining rules will have the effect of aligning the amount of margin money required to be held in a customer's account to the risk of the portfolio as a whole, calculated through simulating market moves up and down, and accounting for offsets between and among all products held in the account that are highly correlated (for example, options on the S&P 500 Index, "SPX", can be offset against options on the S&P 500 Depositary Receipts, "SPY", or options on DIAMONDS (DIA) can be offset against SPX options). Current practice is to require margin based on set formulas for various strategies (i.e. some spread strategies require a certain minimum margin), regardless of what other offsetting positions were held in the account and regardless of potential market moves. For some positions the margin requirements may not change significantly, but for other positions, such as owning a protective put against a long stock position, the difference may be sizable. This is appropriate in that the margin calculation accounts for the fact that the risk of one position (long stock) is offset by the other (long put).

This will make a huge difference to the margin requirements of certain option positions as some of the examples in this document shows:


Long 500 IBM @ $91.25
Short 5 calls IBM APR 95 @ $ 2.78
Strategy margin is 50% of stock less the short option premium or $21,422.50
Portfolio margin requirement is $5,504.00


Long 500 IBM @ $91.25
Long 5 puts IBM APR 90 @ $ 2.50
Strategy margin is 50% of stock plus full payment for put or $24,062.50
Portfolio margin requirement is $1,878.00


(Long must expire on or after short)
Long 50 calls IBM APR 90 @ $5.45
Short 50 calls IBM JUL 100 @ $2.28
Strategy margin requires full payment for long option and
appropriate margin on short option position or $74,750.00
Portfolio margin requirement is $14,106.00

Not mentioned in the examples is a comparison of the collar under the current and new rules. Without pulling out my calculator, it's obvious that the collar margin will be competitive with the debit spread margin. Harking back to The Great Collar Vs Vertical Debate, this might just tip the balance in favour of collars.

It is a marginal advantage, but at least if the underlying tanks on you won't lose the cost of carry on the long call.

The new rules are long overdue and will certainly be welcomed.

03 January 2007

Counting My Chickens

Those of us who like to try and trade normal wave structure (whatever that is) must be feeling as if said wave structure had been cancelled indefinately... at least as far as the stock indicies are concerned.

We've all stared disbelievingly at the SP500 for several months now so no need for me to post a chart, but just in case you've been visiting Venus or somewhere over the last months, it's gone pretty much straight up without a breather.

I like to write premium over the indicies in the form of strangles/condors and suchlike and leg into them off what I think may be swing points. More recently, because of the pathetic volatility and relentless boomage, I've tried to have a mixed gamma position in the form of put backspreads written at a credit (My thinking was to position for a correction but still profit if it just kept going up). This has worked pretty well, if not unspectacularly, but at some stage I want to get back to short gamma again...

...and I've done that this expiry. So far the momentum in the SP looks to be slowly abating and looking a tad toppy, to me at least. This first trading day had me thinking I'd have to defend the short calls... then.... a selloff! OMG!

Could this be the start of a long overdue correction? (in the normal wave structure style?). The Dow is still green as I'm typing this but the other indicies are red after being up quite strongly.

I might be counting my chickens, but I think the top is in for this expiry. It will make a nice start for this year if this short gamma position goes out with a whimper.

My $0.02

01 January 2007

The Great Vertical vs. Collar Debate

Actually, it was more of an argument than a debate...

Actually, is was more like WW3 lol. In any case, it was an episode in which a whole bunch of option traders and ersatz experts behaved very badly and it centered around the synthetic relationship between a bull call spread and a stock collar. Luckily, there was an occasional snippet of options theory plus the odd piece of mathematics which tied all the acrimony around the central theme.

For those unfamiliar with the terms, a "bull call spread" is a spread composed of one long call, plus a short call of a higher strike. This is a limited risk, limited reward strategy; the payoff diagram of which looks something like this:

A stock collar is a position of long stock, a long put plus a short call. The interesting thing is that the payoff diagram at expiry of the options is similar the the one above.

Now a quick lesson in synthetics. A synthetic position is one which duplicates the risk profile of a natural position. So in our example above, the bull call spread can be viewed as the natural position. The stock collar, if the strikes prices are the same, can be viewed as a "synthetic" bull call spread, since the risk profile is identical. Both positions, if initiated at the same time, and held till expiry will have the same risk and the same reward. There are some non transparent and subtle differences between these two strategies which we'll get into in a minute.

The argument started when one group, lets call them "group O" made a case for collars being superior to verticals (i.e. bull call spreads) in all cases. viz:

The risk graph of a collar and bull call spread are the same, but that is where the similarities end.
You have a much better chance of making money over the long run with collars than bull call spreads because you are always in the position and the stock acts as a flotation device by which you remain at equilibrium.

The problem with a call spread (which is not like the collar) is that if you purchase an OTM call spread the stock can go up and you still lose money if the stock does not appreciate beyond the b/e point. Then when the options expire, you have to put on a new vertical call spread. Because of the run up in the stock which you may not have capitalized on, you will likely have to pay much more for the same vertical spread out the next month or move up a strike. If this keeps happening on a slowly drifting higher stock you could be chasing profits all the time without actualizing any. It is a non-fluid trade because of the starting and stopping effect of moving options around every month.

The collar is superior to the vertical because you will be in the stock at all times and do not run into the static fluctuations inherent in an option only strategy. Yes, you have options in the form of a short call and long put, but that is what you want with regard to the horizontal lines of the PNL or Risk Graph of this trade. It is the horizontal line of the stock with the collar that flows while the horizontal line on a vertical has to be moved every month which can disrupt profitability.

Though the profit and loss graphs of a vertical spread look the same in any given month, they are drastically different when you compare spreads v. collars over several months (or longer). It is for this reason that I think the collar is a greatly superior trade than a vertical. It is why guys who are poor at picking market direction can make a fortune trading collars but have a more hit-or-miss track record with verticals. This is an important distinction!

The opposing group, let's call them group E, thought this was nonsense. Whether it is or not might require another 5o pages of WW4 to sort out lol.

However, having survived the conflagration, which spanned several bulletin boards and many countries, I have come to the following conclusions:

*Any talk of difference in the two strategies in rolling the short strike is nonsense, they are the SAME call. We can effectively strip away the short strike and this leaves us with a natural call and a synthetic call (long stock/long put) for the true comparison.

*There is a difference here in that we pay the cost of carry up front when we buy the natural, whereas the cost carry is "pay as you go" for the synthetic.

*So if the underlying takes a big hit early in the life of the strategy, we cop the additional loss of the cost of carry on the natural.

*"Dividends, capital returns and these types of situations can be detrimental with a bull call spread where the short call is at risk of assignment. The long call will not hedge the div if one is assigned on the short call the day before x-div, so that in itself can create a big difference in the profit/loss between the two strategies if the bull call is not managed properly under these types of conditions." (kudos to "sails")

*"As the interest component is usually around the risk free rate and margin lending is well above the risk free rate, There is an advantage to leverage at a lower interest rate." (kudos again to "sails")

Conclusion (so far): Neither is superior at inception. Obviously if you already hold the stock and you want that sort of risk profile, a collar is a shoe in. If not already holding stock, I personally would go for the bull call spread (if I wanted that risk profile)

Ultimately, the differences lie in the nuances in extreme circumstances, otherwise they are virtually equivalent. As we cannot predict extreme circumstances, the superior strategy for any given extreme, can only be decided in retrospect. My view is either strategy can be used with equal success. Some still don't see it that way.

Result: an uneasy truce. :)