Daily Rules, Proposed Rules, and Notices of the Federal Government
An option spread is typically characterized by the simultaneous holding of a long and short option of the same type (put or call) where both options involve the same security or instrument, but have different exercise prices and/or expirations. To be eligible for spread margin treatment, the long option may not expire before the short option. These long put/short put or long call/short call spreads are known as two-legged spreads.
Since the inception of the Exchange, the margin requirements for two-legged spreads have been specified in CBOE margin rules.
The maximum risk remains constant at $1,000 for XYZ market prices higher than $60 because for each incremental increase in the assumed market price of XYZ above $60, the loss on the short option is equally offset by a gain on the long option in terms of their intrinsic values. By calculating the net intrinsic value of the options at each exercise price found in the spread, as in the computation exemplified above, the maximum risk of, and margin requirement for, any two-legged spread can be determined.
On July 27, 1999, the Commission approved the Exchange's implementation of specific definitions and margin requirements for butterfly spreads and box spreads.
Note that a short XYZ May2011 60 call option is common to both two-legged spreads. Therefore, by adding the May2011 60 call options together, the two spreads can be combined to form a butterfly spread as follows:
The margin requirement for a butterfly spread is its maximum risk. The maximum risk can be determined in the same manner as demonstrated above for two-legged spreads. In this example, the net intrinsic values would be calculated at assumed prices for the underlying security or instrument of $50, $60 and $70, which are the exercise prices found in the butterfly spread. The greatest loss, if any, from among the net intrinsic values is the margin requirement. For this particular butterfly spread, there is no loss in terms of net intrinsic values at any of the assumed underlying prices ($50, $60 or $70). Therefore, there is no margin requirement. However, the net debit incurred to establish this butterfly spread must be paid for in full.
In a box spread, a two-legged call spread is combined with a two-legged put spread. The exercise prices of the long and short put options are the reverse of the call spread. All options have the same underlying security or instrument and expiration date. An example is as follows:
The margin requirement for a box spread, unless all options are European style, is its maximum risk. The maximum risk of a box spread can be determined in the same manner as demonstrated above for two-legged spreads and butterfly spreads. In this example, the net intrinsic values would be calculated at assumed prices for the underlying security or instrument of $50 and $60, which are the exercise prices found in the box spread. The greatest loss, if any, from among the net intrinsic values is the margin requirement. For this particular box spread (long box spread), there is no loss in terms of net intrinsic values at either of the assumed underlying prices ($50 or $60). Therefore, there is no margin requirement. However, the net debit incurred to establish this box spread must be paid for in full. In the case of a long box spread where all options are European style, the margin requirement is 50% of the difference in the exercise prices (in aggregate).
On August 13, 2003, the Exchange issued a Regulatory Circular (RG03-066) to define additional types of multi-leg option spreads, and to set margin requirements for these spreads through interpretation of Exchange margin rules. The Regulatory Circular had been filed with the Commission and was approved on August 8, 2003, on a one year pilot basis.
The Regulatory Circular identified seven spread strategies by presenting an example of each spread's configuration, and numbering each configuration, rather than designating the configurations by names commonly used in the industry. The seven configurations would be referred to in the industry as:
On July 30, 2004, the Exchange filed proposed rule amendments with the Commission to codify the provisions of the Regulatory Circular in Exchange margin rules. Included in the proposal were definitions of Long Condor Spread (which includes a Long Calendar Condor Spread), Short Iron Butterfly Spread (which includes a Short Calendar Iron Butterfly Spread), and Short Iron Condor Spread (which includes a Short Calendar Iron Condor Spread). In addition, it was proposed that the existing definition of Long Butterfly Spread be amended to include a Long Calendar Butterfly Spread. The margin requirements, specific to each type of spread, as had been set-forth in the Regulatory Circulars, were also proposed for inclusion in Exchange
Because a number of variations are possible for each basic type of multi-leg option spread strategy, it is problematic to maintain margin rules specific to each.
These two spreads combined are a variation of a condor spread. In a basic condor spread, the number of option contracts would be equal across all option series and the interval between the exercise prices of each spread would be equal. In the above variation, there is a 10-by-10 contract spread vs. a 5-by-5 contract spread, and a spread with a 5 point interval between exercise prices vs. a spread with a 10 point interval between exercise prices. The two spreads in the above example offset each other in terms of risk, and no margin requirement is necessary. However, margin of $5,000 is required under the Exchange's current margin rules, because this variation of the condor spread is not specified in the rules. Because it is not recognized in Exchange margin rules, the two spreads must be treated as separate, unrelated spread strategies for margin purposes. As a result, spread margin of $5,000 is required (on the May2011 70/May2011 60 call spread) versus no requirement (other than pay for the net debit in full), if the two spreads could be recognized as one strategy.
The Exchange proposed a single, universal definition of a spread and one spread margin requirement that consists of a universal margin requirement computation methodology. In this manner, the margin requirement for all types of option spreads would be covered by a single rule, without regard to the number of option series involved or the term commonly used in the industry to refer to the spread. This would eliminate the need to define, and refer to, particular spreads by monikers commonly used in the industry. Therefore, this rule filing would eliminate definitions of each particular spread strategy (
The one exception would be "Box Spreads." A definition for "Box Spread" would be retained because loan value is permitted under Exchange margin rules for box spreads. Box spreads are the only type of spread that is eligible for loan value. They, therefore, need to be specially identified in the rules.
Additionally, the proposed rule changes would automatically enable variations not currently recognized in Exchange margin rules (because only a limited number of specific spread strategies are defined) to receive spread margin treatment.
The Exchange proposed a new definition of a spread as CBOE Rule 12.3(a)(5). The key to the definition is that it designates a spread as being an equivalent long and short position in different call option series and/or equivalent long and short positions in different put option series, or a combination thereof.
Amendments to CBOE Rule 12.3(c)(5)(C)(4) would implement language specifying how a margin requirement is to be computed for any spread that meets the definition, and limit eligibility for spread margin treatment to spreads that meet the definition. The computational method would require that the intrinsic value of each option series contained in a spread be calculated for assumed prices of the underlying security or instrument. The exercise prices of the option series contained in the spread would be required to be used as the assumed prices of the underlying security or instrument. For each assumed price of the underlying, the intrinsic values would be netted. The greatest loss from among the netted intrinsic values would be the spread margin requirement. As an example, consider the following spread:
This spread is a variation of an iron condor spread. It consists of a put spread and a call spread, with all options covering the same underlying security or instrument. There are an equal number of contracts long and short in both the put spread and call spread. The short options expire with or after the long options (with, in this case). It is assumed that all options are of the same exercise style (American or European). This spread would, therefore, be eligible for the spread margin requirement computation in this proposed rule amendment.
Note that in this example, the interval between the exercise prices in the put spread is greater than the interval in the call spread. In a basic iron condor spread, these intervals are equal. This particular configuration is not recognized under current Exchange margin rules. Therefore the component put spread and call spread must be viewed as separate, unrelated strategies for margin purposes. Under current Exchange margin rules, there is a $1,000
The greatest loss from among the netted intrinsic values is $1,000.
It can be intuitively shown that the put spread and call spread in the example do not have $1,500 of risk when viewed collectively. If the price of the underlying security or instrument is at or above $60, the put spread would have no intrinsic value. At or below $65, the call spread would have no intrinsic value. Thus, both spreads would never be at risk at any given price of the underlying security or instrument. Therefore, margin need be required on only one of the spreads--the one with the highest risk. In this example, the put spread has the highest risk ($1,000), and that is the risk (and margin requirement) that would be rendered by the proposed computational methodology.
In summary, the proposed rule amendments would enable the Exchange, for margin purposes, to accommodate the many types of spread strategies utilized in the industry today in a fair and efficient manner.
After careful review of the proposed rule change, the Commission finds that the proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.