Calculating the current implied volatility of an option or the entire options chain of listed options is quite straightforward. However the use of these implied volatilities in risk measurements has varying implications. This article studies how different volatility surface methods can result in very different stress risk calculations for an equity options portfolio. Furthermore is shows the impact on portfolio margin calculations. Several years ago, Customer Portfolio Margin was introduced for equity options positions. The margin calculations are performed by The Options Clearing Corp (“OCC”) using their TIMS methodology. The methodology is stress test based, where each underlying is shocked by various percentage moves, typically about 8% for indices and 15% for single stocks. The worst case loss for each underlying is calculated and aggregated using some aggregation logic.
Since it is stress test based the implied volatility surface used to perform the simulations plays an important part in the results. For many years the OCC followed a methodology of cleansing options closing prices to ensure no arbitrage conditions occurring and they employed certain volatility surface corrections to ensure reasonable stress tests.However in mid 2014 the OCC changed their methodology, and the volatility surfaces are no longer smoothed. The result of this has been deterioration in the portfolio margin results in some cases. The margin requirements for many deep out the money options jumped dramatically, simply due to the implied volatility used for them bring exorbitantly high. Lack of smoothing retains the “kinks” in the volatility surface in the stress calculations – resulting in many cases where further out of the money options have greater margin requirement than strikes closer to the money. Thus certain long call or long put spreads were actually being assessed as requiring margin, which should never be the case. Such irregularities in the portfolio margin calculations are disturbing as many firms rely on the accuracy and consistency of the calculation from the OCC.
Link to the full research article is below