How to Use SPAN Margin to Inflate your ROI
Hi, this is Michael Gross, co-author of McGraw-Hill’s The Complete Guide to Option Selling and Director of Research here at OptionSellers.com. I’m here with your bi-monthly option seller video lesson. The topic of this week’s lesson is Using SPAN Margin, your key to high returns. This is going to be a good lesson because a lot of you stock option sellers out there have never encountered SPAN and it’s a whole different system when you get into commodities, so we’re going to show you how to use that to your advantage today. Before we do, if you’d like to learn more about SPAN margin, putting it to your advantage in selling commodity options, along with the whole strategy of selling commodity options as a core investment, you’ll want to request you copy of McGraw-Hill’s The Complete Guide to Option Selling: Third Edition. It is available now on our website at a 40% discount off of cover price. You can get that at www.OptionSellers.com/Book.
If you’re watching this video, I’m willing to bet that you have probably sold some type of stock option in the past, not necessarily, but probably. When stock traders first become introduced to commodities or selling commodity options, the term margin is often a point of confusion because margin in equities and stock accounts means something quite different from margin in a futures or option selling account. People sometimes get it confused with, for instance, if you’re using a margin account with stocks you’re borrowing money from your brokerage so you can buy more on leverage. That’s fine, but it doesn’t work that way. In commodities, margin means something different. Now, if you are selling stock options, you are familiar with the concept that if you sell an option you have to put up a margin deposit.
Let’s define margin first so we can apply it to commodities. When you’re selling a stock option, you’re not buying anything so there’s no cost to it, so you have to put up what? You have to put up a deposit to hold that position when you sell a stock option. We have the formula in the book if you want to see what the actual formula is for holding a stock option and I know some brokerages can change that or alter it or they want more sometimes, and that’s fine, but the important thing to remember is it’s a deposit to hold your position. The entire futures trading system is based on this deposit. When you are trading in a futures account and you want to buy or sell 5,000 bushels of corn, that 5,000 bushels of corn, if it’s trading at $3 a bushel, that contract is worth $15,000. Well, you don’t have to put up $15,000. You may only need to put up $1,000 and you can then benefit from the price move if it goes in your direction or you can lose money if it goes against you. It’s based on that $1,000 you put up. That’s the leverage you get in commodities. Knowing how to use that leverage is a key component when you’re trading commodities and it’s what trips a lot of people up if they try to trade commodities on their own, which brings us to SPAN margin.
SPAN margin is the formula for calculating margin on a commodities option, what your margin requirement will be for that option. What does SPAN stand for? It’s actually an acronym. SPAN stands for Standard Portfolio Analysis of Risk. It’s actually just a formula used by the exchanges to tell you what your margin deposit for that option will be. Unlike in stocks, there’s not a neat little formula I can give you that will show you what your margin is going to be for any option that you sell. Typically when you go to sell an option you either have the software from the CME or you just get it cleared from your broker. After you sell options for a while, you can pretty much guess what that margin’s going to be within $100 or so, so it’s something that comes with experience but you will get the actual number directly from the broker you’re placing it with or, do what most people do, and you can estimate it and you’ll see the exact number after you sell it.
People that really want to get into this, they order the software from the CME. You can certainly do that, there’s a package they have, I think it’s like $500, and then you can plug your option in and see what the margin is. Actually, a lot of the trading platforms now are giving you what your expected margin requirement will be, but that’s the key… it is expected because, one, it varies daily, not a lot. When you sell an option, your margin deposit on that option can vary depending on daily movements in the value of that option. That’s one of the reasons why we keep a big cash cushion in our accounts, to account for those margin swings. Let’s talk a little bit about SPAN now and how you can use it.
Back to our price chart… So, you’re going to trade the coffee market. You’re bearish coffee prices and you decide you want to sell a call above the market. You sell a call for $600, for instance. I can’t tell you what your margin requirement for that option is going to be by looking at it but, from our experience in trading coffee, we can be pretty sure it’s going to be somewhere around 2-3 times the premium. Now, we’ll know that day… all we have to do is we can get it, get it through our system. If you’re trading at home, you might not know unless you call your broker and ask them what the margin requirement is going to be. Based on coffee, this type of option, your margin for that option probably is going to be somewhere around $1,500 to sell the option. Just guessing. If the volatility is higher your margin can go higher, sometimes a lot higher depending on the volatility. If it’s low volatility it might go lower. I remember trading coffee options back in the day where you could sell a coffee option for $500 and your margin was only $500.
So, I’m just trying to give you what it typically might be under a normal trading condition, but this is just an example. Let’s say that the margin requirement to sell this option is $1,200. Your SPAN margin requirement is $1,200. 90 days from now when that option expires, and we’ll say theoretically it does, you’ll keep that $600 premium. You posted the $1,200, you made $600, so you made a 50% return on your money in, let’s say, 90 days, which would be a potential target of timeframe you’d want to sell the option. A lot of people would say, “I made 50% in 90 days. If I do that 4 times a year, I’m probably doing pretty well in my portfolio.” Now, it doesn’t work out that way, nice and neat, and you may not even want to trade coffee options again and you’re going to have some losses and everything else, but that gives you a pretty good idea of the type of leverage and the type of potential return that using SPAN can provide. You don’t get that in equities. I’ve traded equity options and I know what the margin is. Usually you’re lucky if you’re making 1-2% by the time the thing expires.
This is what draws a lot of equity investors to commodities is a bigger bang for your buck and that all starts with SPAN margin. If you come into commodities as a new investor, the biggest thing you want to understand is that leverage can work both ways. That where positioning your portfolio comes into play, that’s where risk management comes into play, but if you’re doing those things right it puts you in a position to take the advantage of a lot more powerful leverage in the commodities markets. Now, you don’t need to understand every aspect of SPAN margin to be a successful commodity option seller. The important thing to remember is, one, it’s a lot lower than it is for equities and that provides you with a lot of leverage. The second thing to remember is that it’s completely different from the way margin is calculated in stocks. It’s a different ball game. If you’re going to trade commodity futures options, you should understand that SPAN is a big part of it. It’s what makes the potential high returns possible.
I hope you found this week’s lesson helpful. We’ll look forward to talking with you in two weeks. In the meantime, if you’d like to learn more about working directly with us in an option selling portfolio, I do recommend our Option Seller Discovery Kit. It is available on our website for free at www.OptionSellers.com/Discovery . It’ll tell you all about our managed programs we have available for high net-worth investors who would like to sell options on commodities and use the SPAN system. It also comes with a 30 minute DVD of James Cordier giving his seminar to high net-worth investors on selling option premium. I hope you found this week’s lesson helpful and we’ll talk to you in two weeks. Thank you.