Portfolio Margin – Useful and Dangerous Leverage

February 7, 2009

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Give me a lever long enough and a place to stand and I will move the entire Earth

– Archimedes

Margin Basics

Whether you examine the property portfolio of a real estate tycoon or the portfolio of a successful private equity company, you will find a common thread that magnifies returns for each… leverage! It is no different in the stock market. In fact, each of us who trades options takes advantage of the leverage they afford us every day.

Leverage simply means using financial instruments, or borrowed capital, such as margin, to increase the potential return of an investment.

Since we spend our days on the member's site discussing leverage through options, the use of margin sometimes gets less attention than it should, so here’s a quick refresher:

1.You CAN use margin (borrow from your broker) to purchase stock.

2. You CANNOT use margin to purchase options but there are MARGIN REQUIREMENTS for certain spread positions that we like to take.

This is intuitive when you think about the movements of options relative to those of stocks. Options can move by 20%, 50%, 100% or more on any given day, even if the underlying stocks move just a fraction of those amounts. In fact, the frequency with which a stock will drop 50% in price in a very short time period is so low that brokers are currently willing to lend you your entire cash reserves to purchase stock.

Example

If you were to deposit $100,000 in your account, you can borrow another $100,000 from your broker to purchase more stock. This is represented in our account as follows:

Cash: $100,000

Stock Buying Power: $200,000

Option Buying Power: $100,000

Let’s assume we purchase 2,000 shares of a $100 stock, costing us $200,000. If the stock doubles in value to $200, our $200,000 turns into $400,000 and since we borrowed $100,000 from our broker, we can pay that back with interest and keep the remaining $300,000 (minus interest). So, the stock went up 100% and our account went up 200%%!

The benefit of margin is obvious but it doesn’t come without drawbacks. Had the stock dropped by 50% from $100 to $50, the $200,000 would have turned into $100,000 and since $100,000 was borrowed, the broker will issue a margin call and take back its $100,000 leaving us with $0! Hence, both the risks and rewards are magnified if we fully use margin under the current system.

Margin Calls

Despite its potential rewards, buying on margin can be very risky. For example, the value of the stock you buy could drop so much that selling it wouldn't raise enough to repay the loan.

To protect brokerage firms from losses, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) require you to maintain a margin account balance of at least 25% of the market price of any stock you buy long, to hold in your account. Individual firms can require a higher margin level, say 30%, but not a lower one.

If the market value of your equity falls below its required minimum, the firm issues a margin call. You must either meet the call by adding money to your account to bring it up to the required minimum, or sell the stock, pay back your broker in full and take the loss. For example, if shares you bought for $10,000 declined to $7,000, your equity would be $2,000, or only 28.6% of the total value. If your broker has a 30% margin requirement, you would have to add $100 to bring your equity to $2,100, or 30% of $7,000.

You can readily see that for the broker to lend us money to trade options would be a very high risk venture on their part since the options can move by such huge percentages each day and your broker is only in the business of issuing margin in order to benefit from the interest you are paying.

What are the interest rates? At OptionsXpress, where Phil and I trade, they are as follows:

Interest Charged on Margin Balances

$0 – $49,999 8.75%
$50,000 – $99,999 7.75%
$100,000 – $249,999 7.50%
$250,000 – $499,999 7.25%
$500,00 – $999,999 7.00%
Over $1,000,000 6.50%

This is critical information to be aware of. If you are not completely confident that you can generate a return greater than 8.75% on a borrowed capital less than $50,000 or 7.25% for example, on borrowed capital of $250,000 – $499,999 then margin is not yet a prudent choice. However, once you have proven to yourself that you can consistently and competently generate returns of greater than 8.75% then it is a smart decision to exploit margin as fully as possible. Just like the real estate tycoon or the corporate raider, we too can magnify our returns using borrowed capital.

Margin Debt

In 1929, the stock market crash was blamed on extensive speculation and excessive leverage, including margin buying. Following a crisis in the financial industry that left failed brokerages and devastated investors in its wake, the Federal government created the Securities and Exchange Act of 1934, separating the banking and securities industry, and giving the Federal Reserve Board the authority to set margin requirements, which it subsequently did through Regulation T.

Fast-forward 80 years and margin debt is still a measure to be noted carefully. In fact, 24 hours before the Wall Street Journal’s headline on February 25^th, 2007 screamed “Shanghai’s 8.8% Tumble Slams Markets”, Barry Ritholtz noted margin debt for January was at a record high of $285.61B, exceeding even that of March 2000. In our most recent crash last Fall, many accounts both personal and even in hedge funds that were safely within margin requirements, we slammed with margin calls as many stocks dropped 10% or more in single days.

When investors become complacent they have a tendency to assume ever greater risk through increased borrowing while ignoring the second part of the old Ronald Reagan adage: “Stocks go up, stocks go down”

The dangers of margin can be seen in this article “The Fear At The Margin”

New Rules

Starting April 2, 2007 we had a game changer in the form of new margin rules approved by the Securities & Exchanges Commission in December, 2006.

The primary difference is:

Margin will be computed based on risk-based methodologies as opposed to strategy-based methodologies.

The new formulas are designed to more accurately assess an investor’s risk by putting all of the positions in the same underlying stock in one portfolio and then stress-testing that portfolio for a 15% move higher or lower in the stock.

This makes much more sense when you think about the risk you actually assume in your virtual portfolio on certain positions.

Let's take BIDU as an example: BIDU closed on Friday at a price of $124.61. If you thought the stock was still cheap based on the fundamentals you might be tempted to scale into a purchase of some shares. But what if you viewed the chart and considered it to be technically somewhat bearish? You might decide to mitigate risk through a long put purchase – for example, a June $140 put costs $30.10 and covers you through earnings.

Protective Put Risk = Total Cost Basis – Long Put Strike

Total Cost Basis = $124.61 + $30.10 = $154.71

Risk = $154.71 – $140 = $14.71

So, our virtual portfolio margin requirement is approximately $1,471 assuming a 100 share purchase and 1 long put contract purchase. That’s a $15,471 investment that only has an $1,471 virtual portfolio margin requirement! The power of this is really evident by interpolating to bigger numbers. A $154,710 investment has simply an $14,710 virtual portfolio requirement!

The Chicago Board Options Exchange (CBOE) have listed a number of different strategy examples and their accompanying portfolio margin requirements here.

Some are listed below:

These are old samples NOT recommendations!

COVERED WRITE

Long 500 IBM @ $91.25
- Short 5 calls IBM APR 95 @ $ 2.78

Virtual Portfolio margin requirement is $5,504.00.

PROTECTIVE PUT

Long 500 IBM @ $91.25
- Long 5 puts IBM APR 90 @ $ 2.50

Virtual Portfolio margin requirement is $1,878.03

DEBIT SPREAD

· Long 50 calls IBM APR 90 @ $5.45

o Short 50 calls IBM APR 100 @ $ 1.16

Virtual Portfolio margin requirement is $19,089.00

NON-CONFORMING DEBIT SPREAD (Long must expire on or after short)

Long 50 calls IBM APR 90 @ $5.45
- Short 50 calls IBM JUL 100 @ $2.28

Virtual Portfolio margin requirement is $14,106.00!

LONG CONDOR

· Long 50 calls IBM APR 85 @ $8.99

o Short 50 calls IBM APR 90 @ $5.45

· Long 50 calls IBM APR 100 @ $1.16

o Short 50 calls IBM APR 95 @ $2.78

Virtual Portfolio margin requirement is $6,221.00.

NON-CONFORMING LONG CONDOR (All options must expire at same time)

· Long 50 calls IBM APR 85 @ $8.99

o Short 50 calls IBM JUL 90 @ $6.82

· Long 50 calls IBM APR 100 @ $1.16

Short 50 calls IBM JUL 95 @ $4.12

Virtual Portfolio margin requirement is just $4,638!

Does Your Broker Offer Portfolio Margin?

I would highly encourage you to contact them to determine if they are offering portfolio margin and check to see what the qualifications are. Consult your financial advisor as virtual portfolio margining is not for everyone but, as Peter D said when he got his this week – it's like being given the keys to a Ferrari under his excellent strategy.

Impact of Portfolio Margin

While the overall impact of portfolio margin is still to be fully determined after its first full year, we already see an increase in overall option activity, leading to a much higher VIX as well as an increased demand for longer term long put options. By purchasing relatively inexpensive (on a per day basis) longer term long put options, traders can now fully protect their stocks with minimal portfolio margin requirements. Trades that originally seemed conservative, such as our KMP-style trade (which we will revisit in another post), become increasingly attractive as we can not only hold a low risk position but also benefit from the cumulative effect of short call premiums on a regular basis.

We want to take full advantage of products that allow us to make sensible use of maximum leverage. We may not be able to move the entire Earth but I think we can have quite an impact on our virtual portfolio!