Safer Margins for Option Trading: How Accuracy Promotes Efficiency

Margin requirements are designed to control the default risk inherent to commitments undertaken by traders writing options. Much like similar institutions, the Tel Aviv Stock Exchange first adopted a system based on the Standard Portfolio Analysis of Risk (SPAN), which sets required levels of options margin according to the most pessimistic of 16 possible outcomes. Seeking to lower the probability of default without adversely affecting liquidity, the Exchange switched in 2001 to a more detailed margin system based on the most pessimistic of 44 scenarios. This unique change provides an ideal laboratory for testing the impact of increased margining precision on the efficiency of option trading. Based on a sample of over 3 million transactions, this study demonstrates that the more accurate pricing of default risk over the studied range increases efficiency by a number of measures, including a smaller implied standard deviation and deviations from put-call parity.