Finance Wanted.

By Stephen Edge

Standardized Portfolio Analysis of Risk (SPAN) was developed in 1988 by the Chicago Mercantile Exchange to enhance the margin efficiency of futures and options on futures in the same portfolio. SPAN calculates the likely loss of each position with 16 scenarios of volatility and price change to determine margin across the total portfolio arriving at a one-day risk (or worst-case scenario) for a trader's account.

The key strength of SPAN is that it takes into account the entire portfolio and not just the last trade when establishing margin requirements. It has been widely adopted at many other exchanges including those in Asia.

First of all margin in the futures market is not the same as margin for buying stocks. Futures margin is a performance bond that earns interest in your account while stock margin is money you borrow from your broker to pay for a stock (you pay interest for the loan to your broker). When you buy options outright you really only have to put up the premium to carry the position and no further margin is required. SPAN margining really focuses on the option writing and permits different futures and options months to offset one another.

SPAN uses a standard option pricing model to determine how a contract will perform over the 16 previously mentioned scenarios. Option pricing models typically require five inputs:

* Price of the Underlying Instrument
* Risk-free Interest Rate
* Strike Price
* Time to Expiration
* Volatility

In the pricing model the strike price is known and the risk-free rate isn't important. SPAN then takes the last three inputs, time, volatility and price of the underlying and performs the following 16 scenarios to arrive at a loss or gain value over each option and future.

Scenario 1 Futures unchanged Up
Scenario 2 Futures unchanged Down
Scenario 3 Futures up 1/3 range Up
Scenario 4 Futures up 1/3 range Down
Scenario 5 Futures down 1/3 range Up
Scenario 6 Futures down 1/3 range Down
Scenario 7 Futures up 2/3 range Up
Scenario 8 Futures up 2/3 range Down
Scenario 9 Futures down 2/3 range Up
Scenario 10 Futures down 2/3 range Down
Scenario 11 Futures up 3/3 range Up
Scenario 12 Futures up 3/3 range Down
Scenario 13 Futures down 3/3 range Up
Scenario 14 Futures down 3/3 range Down
Scenario 15 Futures up extreme move Unchanged
Scenario 16 Futures down extreme move Unchanged

Volatility is decided by the Exchange and the price range covers the maintenance margin also set by the Exchange.

Let's take a look at how SPAN handles calls and puts in writing strategies. Let's suppose you enter into a put credit spread on the Japan Government Bond future (JGB) with a delta of 0.10. The SPAN system will arrive at an initial margin requirement of say 20,000 Yen. Remember that SPAN assesses the total portfolio risk so if you add a call credit spread with an offsetting delta of -0.10 SPAN no further margin will be required. Without SPAN you would be required to post a margin for each position. As you can see this allows you to use less money to carry more positions and generate commissions for your broker.

Another consideration of SPAN are deep out-of-the-money (OTM) options which could be more risky to the portfolio than the scanning range covers. SPAN arrives at a Short Option Minimum to mitigate this risk. Each contract is assigned a Short Option Minimum Charge by the Exchange. All short options, are totaled and multiplied by the appropriate short option charge resulting in the Short Option Minimum. The Short Option Minimum isn't directly added to the portfolio risk but represents an absolute minimum or floor margin for the portfolio. The greater of the Short Option Minimum or the margin calculated under SPAN becomes the portfolio's margin.

SPAN treats all contracts months the same so a December future will have the same margin requirement as a June future. Unfortunately, contracts don't necessarily move by the same amount. SPAN adds Intermonth Spread Charge to account for this. SPAN also allows option contracts to be included in the Intermonth Spread Charge by creating a futures equivalent position from the options delta. Thus a more accurate Intermonth Spread Charge is realized.

Finally, SPAN also allows for increased margin for contracts in their last month before delivery. As contracts are more likely to be exercised more money will be required.

If you trade options understanding SPAN really isn't that difficult and is rather intuitive.

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