Portfolio Margin

If you are considering investing in our more sophisticated solutions that entail short selling, your account will need to be approved for margin trading. Most investors are familiar with RegT margin requirements which has been the traditional method of calculating margin requirements for decades. Under RegT, margin requirements are determined on a position by position basis. Portfolio margin looks at the total portfolio risk, taking into consideration hedged and offsetting positions, and thus better aligns margin requirements with the actual risk of the portfolio. This section is designed to give you a better understanding of how portfolio margin works.

Portfolio Margin quick overview

Portfolio margin, in the US, is a relatively new margining system approved by regulators in 2007. It was designed for and used primarily by options traders, especially sellers of option premium, but can provide a more efficient use of capital for equity investors, which was previously only available to dealers and hedge funds. When used in combination with index level ETF’s there is tremendous flexibility to more efficiently adjust your portfolio exposure by taking advantage of portfolio margin, without assuming any additional leverage.

The following press release from the Chicago Board of Options Exchange introducing portfolio margin in December 2006 highlights the key features. You can click on it to enlarge.

Who sets limits on margin and why is it important?

In order to maintain a stable market and avoid forced liquidations from too much leverage in the system, it is in the public interest for regulators set limits on how much you can borrow against your portfolio to purchase additional stocks.

Advances in computing power and portfolio risk analysis software.

Portfolio margin was enabled by the ability to run simulated stress tests on large portfolios to assess the potential losses to a portfolio as a whole, upon the occurrence of an extreme market move. This technology and expertise was not available 50 years ago when Reg T came about.

Performing a stress test on your portfolio.

The idea here is to ensure that your portfolio has sufficient margin in the event of an extreme market event. It is somewhat akin to the way engineers design around the 100 year floodplain. Portfolio margining is a methodology for calculating a customer’s margin requirement by ‘‘shocking’’ a portfolio of financial instruments at different equidistant points along a range, representing a potential percentage increase and decrease in the value of the instrument or underlying instrument in the case of a derivative product. For example, the calculation points could be spread equidistantly along a range bounded on one end by a 10% increase in market value of the instrument and at the other end by a 10% decrease in market value. Gains and losses for each instrument in the portfolio are netted at each calculation point along the range to derive a potential portfolio-wide gain or loss for the point. The margin requirement is the amount of the greatest portfolio-wide loss among the calculation points.

Eligibility

A lot of examples you will see about portfolio margin relate to sellers of option premium. It was originally designed with them in mind, and the TIMS margin system which runs the daily stress tests on your portfolio is run by the Options Clearing Corporation. This is why today, even if you do not trade options in your account, you are required to have a certain level of options trading experience to qualify for portfolio margin. This is generally referred to as Level 4 options trading approval which entails the ability to sell naked puts and calls. On your account application you will be asked about your investment objective, net worth, overall trading experience, and level of option trading experience.  You must meet all of the following six requirements:

1. You must specify “trading profits” or “speculation” as one of your investment objectives.
2. You must have executed at least 100 prior trades (this is defined as stock trades + options trades + futures trades = 100 total trades lifetime).
3. You must have a Good or Extensive Knowledge Level for that product, in this case, Options.
4. You must have a minimum of two years trading experience with Options. Applicants who have completed the teaching exam for Options are exempt from the two year experience requirement.
5. Your liquid net worth must be greater than $100,000.
6. Your net worth cannot be less than your liquid net worth.

As you can tell, it’s still very much tailored to option traders, so even though we don’t use options or leverage in our strategies, we still need to meet the options related qualifications  to use the features of portfolio margin to implement our strategy.

Example

The following shows an example of the limitations of RegT and why we might need to use the features of portfolio margin to adjust our exposure. Let’s say you have a portfolio of $1,000,000 and are currently short the S&P 500 using the SPY ETF. Columns 1 through 3 show the style weights for the S&P and the implied dollar exposure to each style, by way of your short position in the SPY. Now let’s say you wish to tilt 50% your portfolio in favor of the Value stocks and 50% against Growth stocks. The implementation box at the bottom shows the trades that are required using the  style ETF’s to implement the change, shown in column 4. The resultant exposure is shown in column 5 & 6, and graphically in the two bar charts.

Margin Analysis: Under RegT margin rules, you can typically borrow up to 100% of your account equity, in this case $1,000,000. Your short position in the SPY would require you set aside $500,000 in equity (50% of the short sale amount), which would leave the ability to borrow up to another 50% of your portfolio value, so $500,000. You would need to set aside $250,000 to short the Growth ETF (50% of $500,000) which reduces your borrowing capacity to $250,000. To buy the Value ETF, you would need to borrow $250,000 (50% x $500,000), which would absorb the balance of your borrowing capacity. If we now wish to add a second factor tilt, for example a momentum tilt, it can not be implemented using RegT since it would require additional borrowing, however with Portfolio Margin rules it is possible. Portfolio margin would analyze the potential loss to the portfolio as a whole based on the combined exposure after the tilt has been implemented, not on a position by position basis, so there would still be significant borrowing capacity.

Notice that we have not added any leverage to our account at the time we initiate the positions – the post tilt exposure is still $1,000,000 and have not used any options.  If the factor tilts were to move adversely then leverage would be required to the extent of the adverse move. Hopefully this gives you a sense of the added flexibility of using portfolio margin.

Additional Resources

• An overview from Interactive Brokers of portfolio margin, eligibility and mechanics.
• This is a form from Interactive Brokers explaining the risks of portfolio margin. You will need to sign it as part of your account opening process.
• Some excellent articles from The Margin Investor website. The article Portfolio Margin 101 is very helpful.