| The
Existing Margin Rules
The
term margin means to buy securities,
or establish a short trade position,
using money borrowed from your broker
(or the broker's clearing firm). The
amount of margin brokerage firms can
offer is limited by Regulation T and
set by the Board of Governors of the
Federal Reserve System. Initial
margin refers to the amount of
margin needed to put the trade on
and maintenance margin refers
to the amount of margin that must
be maintained over time, which usually
is less than the intial margin requirement.
The
existing margin system dictates that
margin is utilized and calculated
based upon each trade deployed and
varying according to the trading strategy
used. Currently, the maximum amount
of initial margin on a straight stock
purchase is 50%. Thus you could buy
IBM on margin at $91.25 by putting
up only $45.63. Your account might
for example include five different
types of trades, such as long stock,
a covered call, a debit spread, a
long condor and so on. The margin
requirement for each of these strategies
is uniquely different - if margin
is even available - and set according
to rigid formulas. The risk profile
of any one type of trade strategy
does not affect or offset any other
held in the same account.
Thus
in a very simple case, if you purchased
three different stocks on margin (ex:
DELL at $25, IBM at $91.25 and GE
and $32) and IBM was dropping but
the other two stocks were up, you
would at some point get a margin
call (be required to put more
equity into your account) on IBM.
The fact that the other two stocks
were up significantly would not matter
one whit; their increase in value
would not in any way offset your margin
risk, and you would get the margin
call.
For
that matter, you have to put up 50%
of the amount of the stock (the net
amount at risk, essentially) even
if you have purchased a protective
put that makes a loss impossible!
For example, if you bought a stock
at $20, wrote the 20 Call and bought
the 20 Put for the same expiration
month as the call - a trade known
variously as a collar or hedge
wrapper - there literally is no
risk to you or your broker in the
trade, even if the stock goes to zero.
Yet under current rules you would
be required to put up 50% of the full
stock price (less call premium) plus
the full amount needed to buy the
long put. Does this make a lot of
sense in a true riskless trade?
While
I am no advocate of offering every
trader 1929-style leverage for speculation,
margin requirements should be aligned
with the position's true risk. Portfolio
margin simply applies the concept
of risk alignment across the entire
portfolio.
The
New "Portfolio Margin" Rules
In
December 2006 the Securities and Exchange
Commission (SEC) approved rules for
the Chicago Board Options Exchange
(CBOE) and NYSE that will allow investors
to put up less collateral when executing
certain trade strategies. The SEC
expanded a year-old test program that
sets collateral requirements based
on the potential loss for the entire
account instead of upon the risk of
loss of each individual trade without
regard to other trades in the same
account. These new rules, called portfolio
margining (because margin will
be based on the account's overall
risk profile) take effect April 2,
2007 and will dramatically reduce
the amount of money investors must
lock up to execute many options trading
strategies. U.S. futures markets and
most European and Asian exchanges
for many years have employed risk-based
margining similar to CBOE's new rules.
The
new portfolio margin requirements
will be equal to the maximum potential
loss on a portfolio based on an
increase or decline of as much as
15% in the value of each investment
held in the same account. Unlike the
current Federal Reserve rules, the
new rules will have the effect of
aligning the amount of margin money
required to be held in a customer's
account with the risk of the portfolio
as a whole, calculated through
simulating market moves up and down,
and accounting for offsets between
and among all products held in the
account that are highly correlated
(for example, SPX options on the S&P
500 Index can be offset against SPY
options on the S&P 500 Depositary
Receipts but not against stock). The
term "portfolio" in this
context refers to securities in the
same account; securities in one account
will have no effect on margin in another.
The
operation of portfolio margining will
not be simple, and could only occur
in a highly computerized environment
where software can continuously make
the required computations. The new
margin requirement is computed by
"stressing" or "stress
testing" an account at ten equidistant
intervals (valuation points) representing
assumed market moves, both up and
down, in the current value of the
underlying security or index. Gains
and losses at each valuation point
are netted and the greatest net
loss among the valuation points
will be the margin requirement for
that portfolio. For stocks, stock
options, narrow-based indices and
security futures products, the amendments
require assumed up/down moves of ±15%
as the end points.
Now,
that's different. As noted, this concept
has been around for awhile and has
worked well where deployed in U.S.
futures markets, Europe and Asia.
Positions that are up will offset
positions that are down. And even
if a position is seriously down, the
margin requirement will be measured
against the value of the portfolio
(the account) as a whole. Of course,
if the whole account is going to hell...
there's going to be a big margin call.
Customers
are supposed to have three business
days in which to resolve a margin
deficiency instead of one business
day. It will be interesting to see
if all brokerage firms (or more to
the point, their clearing firms) will
allow three days.
Benefits
for Covered Calls and Protective Puts
For
some strategies the margin requirements
may not change significantly, but
for other positions, such as long
stock with a protective put, the difference
could be absolutely huge, since the
new margin calculation will account
for the fact that the risk of one
position (long stock) is offset by
the other (long put). However, the
new rules will significantly lower
the margin required on covered call
positions, as well, at least in circumstances.
"In
many cases, margin requirements for
positions such as covered calls, protective
puts and certain spreads will drop
by 75% or more," said Randy
Frederick, CyberTrader's derivatives
director.
The
two following examples from CBOE illustrate
the scale of difference in the current
and new margin rules:
| Covered
Call Write |
|
Cost |
Current Margin* |
Portfolio Margin |
| Buy
500 shares IBM |
-
91.25 |
- 45,625.00 |
21,422.50 |
5,504.00 |
| Sell
5 IBM $95 Calls |
2.78 |
1,390.00 |
|
|
| Net
Cost |
- 88.47 |
- 44,235.00 |
|
|
| *The
initial margin requirement under
current rules is calculated on
half the gross stock price less
the credit received from writing
the calls ($22,812.50 / 2 - $1,390.00
= $21,422.50). |
In
the covered call example above, the
portfolio margin amount required to
initiate the trade would be just slightly
more than 25% of the amount needed
for margining under existing Reg.
T rules. The protective put example
below illustrates an even bigger difference,
because the long puts drastically
reduce the risk and in the example
below eliminate the risk.
| Protective
Put |
|
Total |
Current Margin* |
Portfolio Margin |
| Buy
500 shares IBM |
-
91.25 |
- 45,625.00 |
24,062.50 |
1,878.00 |
| Buy
5 IBM $90 Puts |
- 2.50 |
-
1,250.00 |
|
|
| Net
Cost |
- 93.75 |
- 46,875.00 |
|
|
| *The
initial margin requirement under
current rules is calculated on
half the gross stock price plus
the cost of buying the puts ($22,812.50
+ $1,250.00 / 2 - $24,062.50). |
Will
It Roll Out on Time?
I
seriously doubt all brokerage firms
will be ready to offer portfolio margining
by April 2nd. The firms that traditionally
are on the cutting edge, such as optionsXpress
and thinkorswim.com likely will be
ready to go. Brokerage firms will
have to be approved by their Designated
Examining Authority (DEA) in order
to offer portfolio margining to customers,
and the NYSE is the DEA for most of
the CBOE member firms. Each firm must
establish and maintain written procedures
for monitoring the risk of portfolio
margin accounts, which must be filed
with the DEA and submitted to the
SEC, as well. Brokerage firms will
only be allowed to implement the new
portfolio margining rules if these
written procedures have been filed
and presumably, accepted. Then they
have to design web pages, brochures
and mailing materials and all sorts
of electronic files to accomodate
the new structure.
Brokers
are still very much reacting to the
new order, and none of them has its
new margin procedures manual ready
to go; and the stress-testing algorithms
have to be exhaustively tested and
debugged. Brokers that for any reason
are not ready on the great gittin'-up
morning in April will continue to
apply Regulation T guidelines.
Final
Thoughts
"The
new margin rules will enable countless
investors to employ trading strategies
that previously were prohibitively
expensive for all but professional
traders," said William J.
Brodsky, CBOE Chairman and CEO. Them's
scary words. I have visions of retail
investors and traders putting on far
more risk than they can really handle.
After all, the entire point of the
new portfolio margin rules is to significantly
increase trading leverage so that
money is not tempted to go where the
bigger leverage is already available
(futures, Europe, etc.).
What
is totally unknown at this point are
the account-size or suitability requirements
that brokers will impose on clients
as a precondition to using portfolio
margin. Will brokers give the maximum
possible margin to every Tom, Dick
and Harriet? Some clients may be allowed
more margin based on net worth, depth
of experience, history of losses with
that broker, etc., but you can expect
this to vary by broker. My guess is
that brokers will want to dip a toe
into the water and get some experience
with the new system before broadening
the base of qualified customers, but
this may not be the case.
An
interesting question is whether the
new margin rules will create a demand
out of thin air for protective puts
on long stock positions. If so, the
demand could increase put prices,
certainly those within a few strikes
out of the money. Put premiums tend
to be a tad smaller than call premiums
at or equidistant from the money,
and it remains to be seen if this
historical price skew will be affected
by greater put demand, assuming that
demand for puts actually does increase.
This
issue's Question and Answer:
Dividends and
Early Exercise of Calls
Question:
I
know that ITM calls can be exercised
when the time value disappears close
to expiration and the calls trade
at parity. Is it possible for a dividend
to affect early exercise of calls?
Answer:
Early
exercise is only a concern with ITM
options, of course, since it would
make no sense to exercise an ATM or
OTM option. You're
right as rain: ITM calls tend to get
exercised when time value is gone,
and when the call trades at or below
parity (that is, at
or below intrinsic value). When the
call actually is trading below parity
the danger of early exercise is even
greater - almost assured. In this
case the professional trader can exercise
early, sell the stock and make an
instant, and guaranteed, profit.
When
the dividend is imminent on a dividend-paying
stock, a similar dynamic is at work.
If the time value of the ITM call
is less than the dividend, holders
will exercise the call to capture
the dividend. Thus if the dividend
is $0.45 and the call has only $0.10
of time value, it makes sense for
the holder to exercise. The bigger
the differential, the more likely
is early exercise. Other factors influence
a decision whether to exercise early
to capture dividends, such as the
stock's volatility and current price
trend, etc. These factors are at work
(unlike in the normal case) because
the holder has to hold the stock at
least a c0uple of days to capture
the dividend. Except on the most stable
and non-volatile stocks, the call
holder will exercise on or right before
the ex-date, then quickly sell the
stock the day after the ex-date. That
is, the trader is taking a risk in
having to hold the stock long enough
(even if only a few hours or overnight)
to receive the dividend, including
the risk that the dividend is priced
into the stock and that, immediately
after the ex-date, the stock will
slide in price by the amount of the
dividend.
Be
that as it may, early exercise on
dividend-paying stocks does occur
in this situation. It is not a big
deal in covered call writing but be
aware of the possibility, particularly
on portfolio stocks that you do not
want to lose.
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