Futures and Options

By John Hintze

Futures and Options

From Cross-Margining to Risk Management, Trading Across The Two Markets Remains Riddled in Complexities

By John Hintze

In the U.S., even the savviest traders and investors can stumble when sorting out the nuances and complexities that distinguish futures from options. On the surface, the distinction may seem simple. Option holders pay premiums for the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

Futures have unlimited risk on long and short positions, establish a fixed price, and require margin on long or short positions. Options, on the other hand, limit risk on positions, establish floor or ceiling price protection, and don't always require margin on long or short positions. In Europe, apart from the differences in the structures of futures and options, the transactions are treated largely the same from regulatory and margin perspectives. Not so in the U.S., where different regulators, bankruptcy codes and customer protection rules require them to be traded in different accounts.

That raises significant hurdles to using options and futures in a coordinated trading and hedging strategies, even though the financial instruments often can be complementary.

Futures exchanges emerged in the mid-1800s to enable commodity producers such as farmers to hedge risk. In 1919, for example, the Chicago Butter and Egg Board became the Chicago Mercantile Exchange, which in recent years has merged with the Chicago Board of Trade and the New York Mercantile Exchange. Currently, there are only a scant number of futures exchanges in the U.S., including New York-based ICE Futures. While the U.S. futures industry has consolidated greatly, the options industry has seven exchanges competing aggressively to offer new products and the fastest trading platforms.

The Chicago Board Options Exchange and the International Securities Exchange are the two biggest options exchanges, and at least two more, one an affiliate of the CBOE and the other to be started by BATS Exchange, are expected to begin operations by early next year.

Firms Facilitate Trading Across Futures and Options; Collateral Hurdles Remain

Chicago's thinkorswim, acquired by TD Ameritrade in January, has been at the forefront of giving retail investors integrated access to future, options, equities and other financial markets since its inception 10 years ago. Clients can now design and execute advanced pair trades – once the domain of professional and institutional traders. And they can analyze portfolios across a range of derivatives and securities by the common underlying asset as well as create a multi-component transaction and route its various legs simultaneously to the proper exchanges.

Like thinkorswim, optionsXpress, Interactive Brokers and other brokerages offering sophisticated electronic trading platforms also give investors what appears to be a single account to trade across futures, options, equities and other financial markets. In addition, they provide analytical and trading tools that sustain the impression of a single, highly integrated account, giving investors the ability to analyze their exposures from a range of risk perspectives while performing ‘what if?' scenarios to construct their portfolios. From the back office, however, the firms – each a broker-dealer and futures commissions merchant (FCMs) – must hold futures in separate accounts, making it impossible for retail and institutional investors to cross margin all the positions.

Cross margining, in turn, enables them to receive tangible benefits from hedging risk by lowering their collateral requirements and boosting their trading power. Cross-margining of futures and securities appeared within reach in April 2007, when the New York Stock Exchange, Nasdaq and the Chicago Board Options Exchange approved 12 broker-dealers to offer portfolio-margin accounts. But even though the securities accounts were designed to include futures contracts, separate regulators and the financial instruments' different customer protection and bankruptcy rules, coupled with the last few years' market mayhem, has impeded any progress.

So a retail investor can buy CME Group's E-mini S&P 500 futures contract and take on a short position using the Chicago Board Options Exchange's equivalent option. Or an institution seeking quick exposure to the S&P 500 index could buy the future and then ease into the underlying stocks, or if it wants to own only some of the index's stocks, it could sell the future and individually sells the unwanted stocks. But today, neither of those investors would get the cross margining benefits for which market makers and proprietary traders received the regulatory nod in 1991.

Nevertheless, market participants that have tightly integrated their broker-dealer and futures-commission merchant offerings provide collateral benefits where they can. The margin system at optionsXpress, which caters to retail investors, requires some additional collateral on top of the regulatory requirement for portfolio margin accounts – a typical approach.

But when customers “have offsetting [futures and securities] positions, we'll go down to the exchange-minimum requirement,” says Gary Morton, vice president of risk and margins at the Chicago-based firm.

Morton says portfolio margin accounts comprise a significant percentage of the firm's customer assets and a smaller percentage of accounts, although he declined to provide details. “I strongly believe retail customers didn't blow up over the last year, like many institutions, because they hedged their positions,” Morton says, adding that the firm wants to lower the $100,000 minimum now required to open portfolio margin accounts, to extend them to a wider swathe of clients. Greenwich, Conn.-based Interactive Brokers has opened several thousand portfolio margin accounts. Its real-time system automatically institutes margin calls when collateral falls below a certain point, so it requires only the regulatory minimum except for some illiquid securities, according to Steve Sanders, senior vice president of product development.

Anthony Scianna, executive vice president of SunGard's brokerage and clearance business, says his firm's technology allows brokerage customers, which include clearer Penson Worldwide and its broker-dealer correspondents, to delineate similarly between house and regulatory collateral requirements.

“It makes a lot of sense to be able to offset financial futures with financial options. Firms have been doing it for years on proprietary level, and it just hasn't been passed down to clients,” Scianna says. Despite the lack of cross margining, broker-dealers, exchanges and vendors have introduced products and services to facilitate trading across those markets.

Jesper Alfredsson, head of algorithmic trading at Orc Software, which provides a cross-market trading platform, notes the trend of investors increasingly moving into new markets to expand their businesses and avoid “being sensitive to an asset class or group of instruments.” He points to a customer focused on trading index options that uses futures as a hedge, “And now they're moving into other CME products that could include natural gas, oil, silver … and using options and futures on these commodities, and options on the futures.”

As a result, Orc continues to expand connectivity to exchanges around the world, most recently to the Tokyo Commodity Exchange in May and has plans to connect to the Dubai Gold & Commodities Exchange. Its algorithmic trading platform, Orc Liquidator, enables firms to pursue trading strategies and quickly adapt them to changing conditions across more than 100 markets worldwide, including futures and options. And Orc Spreader, launched in May, facilitates spread trading, which includes pairs trading, for high-frequency customers specifically seeking arbitrage opportunities in futures contracts and across other markets. Alfredsson notes that typically firms would have coded their own spread strategies, perhaps in Liquidator, and Orc's off-the-shelf solution does that for them.

“We provide the parameters and they can adjust them to adapt the behavior of their strategies,” he says.

The exchanges are also getting into the mix.

The CBOE, created in 1973 by the Chicago Board of Trade, now a part of CME Group, to trade options on stocks, received SEC approval Aug. 18 to allow participants to “tie” hedges before presenting the transaction to the exchange's floor traders. So a member can pair a large order of options with instruments including the related stock, security futures or index futures before approaching the pit and risking value changes, known as delta, in the underlying assets before the transaction is completed. “Rather than trading hundreds of thousands of shares of the SPDRs ETF to hedge the option on SPDRs, we're saying the economically equivalent S&P 500 future, or another equivalent, would be allowed as a hedge under the tied hedge rule,” says Edward Tilly, executive vice chairman at CBOE.

Such developments, however, are really aimed at institutional investors. Peter Bottini, executive vice president of trading at Chicago's optionsXpress, said his firm has integrated futures and securities on the trading screen for three years and is “aggressively promoting both products. “In years past, you might have had a securities account and a futures account with us, and now you can look at all the positions integrated in one place,” Bottini says.

Pair traders using thinkorswim's platform can now program alerts for when underlying assets diverge in value sufficiently to warrant an arbitrage trade, and they can view their trades, or potential ones, in numerical or graphical form. Tom Sosnoff, chief executive officer and founder of thinkorswim, says a customer could buy two E-mini Nasdaq composite futures and sell 10 at-the-money listed SPY calls to achieve a delta- and beta-neutral position that's anticipating the Nasdaq will outperform the S&P 500 and the premium will erode.

Such a sophisticated trade involving multiple underlying assets, in which the relationships between them are expressed in a numerical basis that's traded back and forth, was only available to professional investors even five or 10 years ago. Broker-dealers and FCMS are bringing those two groups of investors ever closer together on the trading end, if not the back-end.

The reason we do it is we believe customers can better offset risk,” Sosnoff says, adding, “We'd love to be able to see them offset margin requirements, but that's out of our control.”

Cross-Market Trading Innovations Continue But Miss Pot of Gold;

Regulators' Harmonization Efforts May Need Extra Kick

Jacob Pechenik started YellowJacket Software in 2002 because some energy-derivatives transactions had become too complicated to negotiate over the phone between counterparties or brokers. By the time a trader quoted various parts of a proposed transaction in fast moving market, the pricing of one or more legs of the deal was likely to have already become irrelevant. Instant messaging (IM) was quickly becoming an ideal mechanism for typing a transaction's multiple terms for distribution to all potential counterparties, except the trader might find himself with 60 IM windows open over AOL or Yahoo.

If an interesting quote was identified, the trader would manually type it into the firm's pricing model, and if he decided to pursue the over-the-counter trade, he would respond affirmatively by IM. Then he would again manually type the data into the firm's books-and-records system. “

The process was cumbersome, very prone to errors, and lacked an audit cover trail,” Pechenik says. So his firm, which was acquired by IntercontinentalExchange (ICE) in February 2008, developed software to put all the trader's incoming and outgoing quotes onto a single screen that strongly resembles an exchange screen. It automatically sends bids and asks to the firm's pricing models, “so you avoid the time consuming and error-prone transfer of data to another system,” Pechenik says.

In the last year, Pechenik says, YellowJacket has added functionality to break apart the trader's over-the-counter (OTC) transactions into its numerous legs – typically standardized futures and/or OTC contracts – and attach the appropriate values to those legs. The software allows the trader to negotiate the transaction as a whole with potential counterparties, and after striking an agreement the components can be broken into separate standardized instruments and sent to the ICE futures exchange for centralized clearing. Immediately afterward, the components are sent to firm's own risk management system and an audit trail of the transaction is recorded.

“In essence, we've taken a process that can take four hours down to 10 seconds, and dramatically reduced errors,” Pechenik says. Pechenik says any complex trading strategies with multiple legs may benefit from YellowJacket, since they tend to be negotiated in a similar fashion. He adds that the technology could be easily leveraged to address similar needs in a range of other asset classes.

Cool technology, as they say in Silicon Valley. But such an innovation is unlikely to be used for complex transactions that include both futures and securities legs, including equity options, anytime soon. Partly that's because U.S. regulations do not permit those components to be offset in investors' portfolios to achieve lower collateral requirements, unless the firm is trading for its own account as a market maker or proprietary trader. The Obama administration has pushed the Commodity Futures Trading Commission and Securities and Exchange Commission to consider how to harmonize their regulations more effectively, to allow for such cross margining.

Portfolio margin accounts require a minimum of 15 percent collateral for equities, compared to 50 percent under the longstanding Regulation T, and that percentage can be reduced significantly when stocks are cross margined with options – and perhaps futures someday. The accounts currently can't hold futures, although they were designed to. Participants at the CFTC and SEC's Sept. 2-3 public hearings on harmonizing the markets mostly agreed cross margining is a priority. Cross margining futures and securities, including equity options, would make complex, multi-market transactions more attractive to investors and their brokers from a capital perspective, especially arbitrageurs who operate on razor thin margins. Even facing the collateral hurdle, however, there's growing demand to trade across markets, warranting some service providers to further facilitate those efforts.

Steve Grob, director of derivatives at U.K.'s Fidessa Group, says large institutions have tended to “silo” their portfolios rather than “think in a multi-asset-class way.” Their broker-dealers – Fidessa's largest customers – are reconsidering that approach, Grob adds, in order to provide more flexible and less costly financial services to their clients. Addressing that trend, Fidessa gave customers of its order-management workstation the ability to set limits on the legs of complex transactions about six months ago. So if some legs are not fully filled the others are automatically adjusted to reduce unanticipated and risky exposure. The European brokerage subsidiary of commodity giant Archer Daniels Midland and other large European customers are piloting the new functionality across equities, options, futures and contracts for differences.

Some large U.S. customers are piloting the functionality with futures and equities, but it will become more relevant when Fidessa introduces equity options into the mix. “That's something we're going to be extending to the U.S. later this fall,” Grob says. Grob acknowledges that, contrary to the norm, retail investors have been at the forefront of trading across futures, options and equities for many years through high-tech brokerages. Institutions, however, tend to pursue very complicated trading strategies, and today they want to understand their components as much as possible.

To that end, Imagine Software will soon offer the ability to “drill down” to the constituent components of exchangetraded funds, which investors may hold directly or through futures or options.

“So you can see your complete exposure to the common underlying assets, regardless of how you entered into the exposure,” says Michael Blakley, director of product management at Imagine, a provider of risk-analysis services.

Blakley notes that the recent credit crisis revealed investors didn't fully understand their risk exposures, and now there's a push toward more transparency. “

Their clients are saying, ‘Prove to me you're diversified and have offsetting risks,'” Blakley says. Blakley notes customers long been able to drill down to the components of their portfolios, but they would have had to construct and maintain the ETF constituent list. Imagine, Blakley says, will do that task for them. Tethys Technology, based in New York and London, has brought risk analysis down to the trading desk, allowing traders to track their overall exposure in real-time and, since late last year, set limits.

“If I hold $10 million of IBM options and I hedge with E-mini futures, and I never want my exposure to exceed, say, by $250,000, the system ensures I never get out of line by more than the specified amount,” says Nitin Gambhir, CEO and founder of Tethys Technologies. All Greek risk measurements for options are calculated in real-time.

Twelve clients of Tethys, which provides algorithmic trading and portfolio management software, are now using the analysis and real-time hedging capabilities. In the next software version, Tethys will introduce a scenario analyzer, enabling clients to create ‘what if?' scenarios, such as what if the S&P 500 jumps 5 percent, or volatility climbs by 3 percent, or a portfolio including time-sensitive derivatives shifts a specified number of days into the future. They'll be integrated with low-impact equity, option and futures trade execution algorithms provided by Tethys.

Imagine and other firms, such as RiskMetrics Group, already provide risk-management tools that can generate similar hypothetical portfolios, but they're typically separate from trading systems. “In our approach, a customer can give traders and risk managers essentially the same view simultaneously,” Gambhir says. He adds that a customers' head trader recently saw his traders collectively exceeding the $3 million risk exposure limit, prompting him to begin hedging with futures to reduce that exposure.

Technology enhancements will continue to facilitate trading across futures and securities markets, but cross-margining is the pot of gold. Prospects of including futures in portfolio margin accounts froze with the credit crisis. However, the technology already exists to allow investors to offset derivative exposures and lower their collateral requirements, and from crisis may spawn opportunity. Three exchange companies for example, are preparing clearing services for credit default swaps, both indexes and single contracts, that will enable futures and securities market participants to avail themselves of risk-based collateral benefits.

CME Clearing Managing Director and President Kim Taylor says that when the exchange company launches the clearing service in the “near term,” CDS-market participants will be able to cross margin portfolios containing CDS index products with single-name CDS exposures to lower collateral requirements. States Taylor: “Part of the reason it was easier [to cross margin] with CDS was that they have features of both futures and securities and there's a lack of clarity about just what kind of animal they are. “So we were able to reach a solution that allows them to be treated efficiently for end users,” Taylor says.

That can't happen yet for institutional and retail investors holding an index future and a basket of single-name options. However, U.S. firms trading for their own accounts, market makers and proprietary trading firms, were approved to cross-margin futures and options contracts in 1991, using a risk-based model to stress test portfolios of instruments in up and down markets. Portfolio margin accounts held by retail and institutional investors already use the same risk-based model to stress test portfolios containing a variety of instruments, including equities, equity options, and convertible bonds. Futures are not included because they are regulated a separate set of rules, including those related to customer protection and bankruptcy. Perhaps most importantly, their regulators are under the jurisdiction of separate Congressional committees, neither of which wants to forfeit power to the other.

Portfolio-margin accounts, which are securities accounts, represent a so-called one-pot solution, in which securities and futures reside in a single account. Anthony Scianna, executive vice president, product management and marketing for SunGard's brokerage and clearance business, says a two-pot approach, in which the futures and securities can be cross-margined across their respective accounts, may be easier to implement in the short term.

The CME promoted that approach after portfolio-margin accounts were approved. Taylor calls it a “very clean” solution that would “create a mechanism by which futures and securities portfolios can be combined purely for calculation of risk, while customer protection, capital requirements and the bankruptcy rules would continue to operate under separate jurisdictions.”

A definitive push by the Obama administration, however, may be necessary to adopt one or the other. At the regulators' hearings, exchange executives and other securities and futures industry representatives spoke much about the benefits of harmonizing the two markets for investors. But little compromise was offered to reach a solution.

William Brodsky, CEO and chairman of the CBOE, emphasized the importance of cross margining, especially to remain competitive with markets outside the U.S. where it is already permitted. But his solution mainly listed changes to be made on the futures side of the fence, including changing laws to permit futures contracts in securities accounts, and for the CFTC to provide an exemption from current customer protection requirements.

“Another step would be for the CFTC to permit a portfolio margin account to be established using the ‘one pot' clearing method utilized in the securities markets,” Brodsky said in his testimony.

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Posted on Sept. 29, 2009