[ by Howard Haykin ]

Amendments Go Effective on 10/26/12 and 1/23/13.

FINRA received SEC approval to amend FINRA Rule 4210, Margin Requirements, related to:  (i) option spread strategies, (ii) maintenance margin requirements for non-margin eligible equity securities, (iii) free-riding, (iv) “exempt accounts,” and  (v) stress testing in portfolio margin accounts.  Effective dates:  10/26/12 for changes to "option spread strategies;  all others become effective on 1/23/13. 

Background and Discussion. Option Spread Strategies in general, allow investors to realize limited reward in exchange for limited risk, and consist of combinations of “long” and “short” call option contracts or put option contracts or combinations of call and put option contracts. Option spreads can be paired in such ways that they offset each other in terms of risk. The total risk of the combined spreads is less than the sum of the risk of such spread positions if viewed as stand-alone strategies. 

FINRA amended the definition of a spread in FINRA Rule 4210(f)(2)(A)(xxxii) to mean a “long” and “short” position in different call option series, different put option series, or a combination of call and put option series, that collectively have a limited risk/reward profile. These must meet the following conditions:

1. all options must have the same underlying security or instrument;
2. all “long” and “short” option contracts must be either all American-style or all European-style;
3. all “long” and “short” option contracts must be either all listed or all OTC;
4. aggregate underlying contract value of “long” versus “short” contracts within option type(s) must be equal; and,
5. the “short” option(s) must expire on or before the expiration date of the “long” option(s).

FINRA amended the definitions for the specific option spread strategies currently recognized in the rule, along with the specific margin requirements associated with each spread, with the exception of a “long” box spread consisting of European-style options.

• The amendments retain this strategy in FINRA Rule 4210 with a maintenance margin requirement equal to 50 percent of the aggregate difference in the exercise prices.

• The revised margin requirements are set forth in FINRA Rule 4210(f)(2)(H) and require that the “long” option contracts within such spreads must be aid for in full.

• The margin required for the “short” option contracts within such spreads is the lesser of: (1) the margin requirements pursuant to FINRA Rule 4210(f) 2)(E); or (2) the maximum potential loss.
• 
  The maximum potential loss is determined by computing the intrinsic value (i.e., the in-the-money amount) of the options at price points for the underlying security or instrument that are set to correspond to every exercise price present in the spread.

• The intrinsic values are netted at each price point, and the maximum potential loss is the greatest loss, if any.

• The proceeds of the “short” options may be applied towards the cost of the “long” options and any margin requirement. FINRA Rule 210(f)(2)(H)(iv) also makes clear that OTC option contracts that compose a spread must be issued and guaranteed by the same carrying broker-dealer and the carrying broker-dealer must also be a FINRA member.

• If the OTC option contracts are not issued and guaranteed by the same carrying broker-dealer, or if the carrying broker-dealer is not a  FINRA member firm, then the “short” option contracts must be margined separately pursuant to FINRA Rule 4210(f)(2)(E)(iii) or (E)(iv).

• In addition, FINRA amended paragraph (f)(2)(N) of FINRA Rule 4210 to similarly conform the margin requirements for spreads that are permitted in a cash account.

The following example illustrates how the maximum loss is determined:

Note to Readers:  To continue reading FINRA's explanation of its rule changes, go to   FINRA RegNote 12-44, October 2012, and, beginning on page 3, follow the discussion in the following order of topics:

• Non-Margin Eligible Equity Securities
• Free-Riding
• Exempt Accounts
• Stress Testing
• Technical Changes

FINRA Staff Contacts.   Direct your questions on these amendments to: 

• Rudolph Verra, MD, Risk Oversight and Operational Regulation;  (646) 315-8811;
• Glen Garofalo, Director, Credit Regulation;  (646) 315-8464;
• Steve Yannolo, Project Manager, Credit Reg.;  (646) 315-8621; or
• Kathryn Moore, Asst GC, Office of General Counsel: (202) 974-2974.