What makes this entire system of cash-OTC-futures-options work is the ever-increasing amount of credit that you receive as you work your way through the chain. Let’s look at the stock market as a prime example:
$100 in shares (cash) is the same as $30 in CFDs (OTC) or $20 in SSFs (futures) or $5 in calls (options) or $5 in puts (options).
The same $100 in shares is supported by at margin calculator least four other products. This has created an additional $400 in credit for just $60 in up-front cash. That is almost a sevenfold increase in purchasing power.
On the face of it, economists and major investors like Warren Buffett are consistently worried that this pyramid of easy credit will cause the collapse of our civilization as we know it. If done properly, the interrelationship between each of these markets was designed to make it less risky, not more risky. The worry may be unnecessary. It’s like saying that if too many people buy car insurance, whether they drive a car or not, it will destroy the car industry. One need not be in direct correlation with the other.
Whatever the case may be, the current system has a built-in checks and balances. There is a requirement that the options be purchased outright, since they are the least expensive, and that when margin is extended it comes in two forms. In the first stage you are extended what is known as an initial margin. This is a percentage of the contract that brokerage or the exchange has deemed to be appropriate for the market’s current volatility levels.
In the second stage of a margin offering is the maintenance margin. The maintenance margin is the absolute minimum amount that trader must keep in his account in order to maintain his position. If the trader cannot keep his account at the maintenance level, then he must put up more money to get back to the initial margin or close his position out. This is known as a margin call.
While the system is far from perfect, it works. If not for the fraud component, major disasters at Société Général and Barings Bank could have been avoided solely based on the various margin calls the traders were receiving on the way down.
Standard Portfolio Analysis of Risk (SPAN)
Whether by design or by chance, in 1988 the Chicago Mercantile Exchange created one of most sophisticated systems for margin calculation around. In light of the fact that the CME is expanding at a rapid rate and acquiring both international and domestic products as part of its stable, the SPAN system will allow the CME to assess account risk in an ever-expanding way.
As excerpted directly from the CME Group web site:
SPAN uses the risk arrays to scan underlying market price changes and volatility changes for all contracts in a portfolio, in order to determine value gains and losses at the portfolio level. This is the single most important calculation executed by the program.
Through its sophisticated calculations the SPAN program takes into account the delta of options, intercommodity spread credits, as well as the amount of volatility affecting the overall account. Based on this calculation, something interesting happens, not just for the exchange, but for the trader as well. When a trader has properly daisy-chained his cash, OTC, futures, and options holdings, margins have a way of almost magically being reduced.