On April 2, 2007, the new Portfolio Margin rules came into effect, which are described at length in a recent CallWriter newsletter. The margin available under the PM rules is huge, as this CBOE margin comparison chart indicates.

Just take a look at that CBOE chart: the purchase of 10,000 shares of IBM at 97.73 would cost $977,300 with no margin. Under Reg-T margin rules, a covered call involving the sale of the IBM April 100 Call would require only $471,950 in cash, while the same covered call trade under the PM rules requires only about $130,000. But, adding a protective put would drop the cash requirement to run the trade to $37,538 under the PM rules - only 3.8% of the cost of the stock. (Don’t forget margin interest on the borrowed funds at over 8% p.a.)

As you know, Americans in general don’t save - our homes have for decades served as our piggy banks (spending derived from home equity loans largely fueled the US economic expansion of the past few years). But the astonishing amount of margin available under the PM rules represents a new source of liquidity for the trading public. Back in the great bubble market, it was not uncommon for traders to hock their homes to get money to trade.

Well, that won’t be necessary anymore for traders who qualify to use portfolio margin, because they will have fabulous liquidity without pulling equity out of their homes.

Use of such high margin will be very tempting and can allow the generation of returns heretofore available only to futures and forex traders. I would expect traders to be the primary users of portfolio margin, not investors.

As noted in an earlier post and as will be explored in future posts, I believe a recession or mini-recession is coming due to the cooling housing market and other factors. Since the stock market is one of the earliest leading indicators of the economy’s growth or recession, we can expect a bear market soon if the economy really is cooling off.

My first question is: if traders make heavy use of portfolio margin, to what extent will the additional liquidity created by trading on borrowed money artificially buoy the market? A major bear market, in which institutions and hedge funds are selling stock holdings and going to cash, will not be staved off by traders using any amount of margin. But how much difference will bullish use of the new margin make?

On the other hand, might traders using heavy portfolio margin for short selling (recall that PM was not available during the February 2007 market selloff) actually exacerbate the decline if a new bear market is initiated?

This is uncharted territory, so no one really knows. It will take a while for PM to become widely used, partly because many brokerages won’t be ready or will only gingerly put a toe in the water at first, but the trading sharpies will be the first on board with it, as always. It therefore may not be entrenched soon enough to make a difference in the near future. But the public tends to make use of new liquidity sources, and this is a big one.

This entry was posted on Wednesday, April 4th, 2007 at 12:30 pm and is filed under Covered Calls, Markets/Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.