Do you understand how equity value impacts your margin?
If the answer is no, then you may be missing out on ‘free’ risk.
Any portfolio that includes option positions may have equity value that can be used to reduce the margin payable. The more of this credit that is used the greater the margin efficiency that can be achieved.
The way in which this margin offsetting works isn’t well understood – which means that a lot of firms may be missing out on what is basically ‘free’ risk: the availability of a credit that means additional positions can be opened without paying any additional margin.
This post describes what is meant by equity value, how it impacts margin and – most importantly – how it can be used to optimise your margin.
What do we mean by equity value?
Before looking at how to optimise the use of the equity value in your portfolio, it’s probably best to define what we’re talking about. There are a few different terms that you may have heard:
- Equity Value
- Net Liquidating Value
- Premium Value.
These are all just different names for the same thing: the current value of any options where premium is paid up front in your portfolio. What is important here is that it isn’t all options. Some options are what is called “futures style”, with daily profit and loss being paid on them, and these do not have equity value. As an example ICE Financial, Commodity and Energy options are all futures style.
The calculation of the equity value, or Net Liquidating Value (NLV) as it is called by the majority of exchanges, is a simple one:
NLV = position * contract size * price
Where position is the number of lots of the option held, with position being positive for a long position and negative for a short position. So, if you have a long position you will have credit NLV and if you have a short position you will have debit NLV.
How does it impact margin?
When most people talk about margin they are thinking of Initial Margin. This is the calculation that estimates potential future losses, using algorithms like SPAN or Prisma. But it is actually the Net Margin that has to be collateralised:
Net Margin = Initial Margin + NLV
It is important to get the signs correct in this calculation. Initial Margin is always a debit, so if you have debit NLV then it will increase your Net Margin, but if you have credit NLV it will reduce your Net Margin.
How do you optimise your margin using the equity value in your portfolio?
As can be seen above, if you have credit NLV then you can reduce your Net Margin. This means that the equity value in your long option positions can be used to reduce the amount of margin that you pay. Not forgetting though that if you have a lot of short option positions they will increase your Net Margin.
And the value of the credit that you get from the NLV can be significant. In a portfolio consisting of a large proportion of long options, the credit NLV can often be larger than the Initial Margin, meaning it completely offsets the Initial Margin.
Unfortunately though, you don’t benefit if your credit NLV more than offsets your Initial Margin. CCPs don’t give you any money back. It’s a case of ‘use it or lose it’. Consequently, you might like to consider trading some additional futures. The IM could be completely offset by the available credit NLV, meaning that your Net Margin could still be zero.
The following example shows how the NLV impacts the Net Margin, and how you can use this to hold additional risk ‘for free’.
Consider a portfolio at Eurex consisting of a mixture of Index futures and options alongside individual equity options. This portfolio contains a large proportion of bought options, meaning that there is a significant credit NLV. The figures are as follows:
Total Initial Margin 6,617,701
Total NLV 55,672,690
Total Net Margin 49,054,989
This means that there is an unused credit of EUR 49,054,989 in the portfolio. So, with the right trading, for example in index futures contracts, more than seven times the risk could be added to the portfolio without needing to pay additional margin.
Where’s the catch?
Actually there isn’t really one. There are however a couple of things to watch out for.
There are limits on the Initial Margin that can be offset by credit NLV. Generally the use is restricted to the same group of products. So for example, if you have an excess credit on an equity position with a CCP you may find that you still have to pay the full margin on your fixed income position with the same CCP.
When an option expires or is exercised the equity value goes with it. So you may suddenly find you have increased margin costs, especially if the option was contributing a large credit NLV but had a low Initial Margin. It is important to fully understand how your Net Margin is being calculated and how it will change over time, particularly on contract expiry.
The following shows how Net Margin can change over time for an option portfolio. Consider just the DAX portion of the portfolio described above. This is made up of options which expire in September 2018 and additional futures and options which expire December 2018 and beyond. If we calculate margin separately for the September 2018 contract we can see how the risk is distributed:
This shows that all of the credit NLV is in the September 2018 expiry positions. When these contracts expire, instead of the portfolio having an unused credit NLV of EUR 17,196,555 there will be a total Net Margin to pay of EUR 13,001,120.
How is margin attribution impacted?
It’s relatively well known that, because Initial Margin is a portfolio based calculation, it isn’t additive; if you calculate margin on, for example, each strategy individually, the total will be greater than the Initial Margin for the total portfolio.
When you add the equity value into this calculation it gets more complicated. It may be that one strategy is contributing all the credit NLV, whereas another strategy has a very high Initial Margin which, when the portfolio is considered as a whole, is being offset by this credit to create a low total Net Margin. This can be seen in the portfolio described above if we calculate the margin split by index and individual equities, and then broken down further by specific index or industry sectors:
Form the table above, you can see the Chemical & Oils portion of the portfolio is contributing 30% of the overall Initial Margin, but has debit NLV. It is therefore getting a “free ride” as far as margin costs are concerned. Conversely, the overall Index strategy is only contributing 34% to the Initial Margin, but is providing 71% of the credit NLV.
Understanding how equity value impacts margin is important in ensuring that all strategies are contributing to margin efficiency.