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August 14, 2007

What's the Flux?

Penny Trading and Portfolio Margining Change Options Biz

By Brad Bailey

The U.S. equities option market, which has grown at an annualized rate of 30 percent since 2000, has undergone a tremendous transformation. However, in many ways, this transformation has been just a rehearsal for what the options market faces this year. Clearly, the options market of 2007 looks very little like the options market of 1999, as the forces of electronification and institutionalization have entirely changed the players-and the profits. Now, the market is in the midst of absorbing two major regulatory changes that will significantly impact capital usage, transparency, liquidity and market structure. There's also the possibility of new types of entrants participating in the marketplace. The penny pilot program and portfolio margining both stand to impact the options market in a profound way.

When combined, these forces are reminiscent of the equities market six years ago, when the penny pilot was first implemented in the U.S. equities market. While the options market and the equities market are quite different, there are similarities that they both share regarding how the markets' structures will evolve in the context of the varied forces coming into play. The penny pilot has been widely discussed, and all of the exchanges have presented their findings, data and recommendations to the Securities and Exchange Commission. The market is now in the waiting room, anxiously pacing back and forth, awaiting the birth of what could possibly be an entirely new market structure.

Portfolio Margining

The other regulatory change, perhaps even more profound, has been the change effecting portfolio margining and creating a regime of risk-based margining for a wider swath of the market.

Portfolio margining will have a huge impact on the margin required in portfolios with stocks, ETFs and options. In some cases, it will decrease margin rates from 50 percent to 15 percent-not an insignificant reduction.

Different firms will handle the extent to which they will provide risk-based margining to different clients. Firms will also have different models, but as a starting point, the Theoretical Intermarket Margining System (TIMS) model developed by the Options Clearing Corp. will be the basis of many margining systems. Margin computations will look at equity and related options as a portfolio. TIMS analyzes the potential loss in a portfolio as a function of the moves in the underlying equity. Any options that act to offset that move will be reflected in the required margin.

The most basic example of the capital efficiency afforded to option investors/ traders under portfolio margining would be portfolio insurance. For example, say an investor buys 100 shares of IBM at US$105 and buys one October 105 put for US$5. Without portfolio margining, under traditional Reg T margin, the investor would be required to post 50 percent of the equity price (US$5,250) and 100 percent of the put cost (premium) (US$500) for a total Reg T margin US$5,750. Of course, the risk of this position would be minimal, as any downside in IBM is protected by the put option. Under risk-based margining, combining the maximum loss of 15 percent with the increase in put value yields a total margin of under US$500. The potential savings would be greater in complicated, multi-leg options trades. In many strategies, there could be capital reductions of 70 to 85 percent.