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:

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.

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.

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.