Risk-based margin is both a blessing and a curse. But is it for you?
Getting more bang for your buck is a concept most people understand. So when it comes to trading on margin—putting up a portion of the cost of an asset to control all of it—some traders like to use it to leverage their buying power. However, the “one size fits all” approach of margin may not be enough juice for some traders. Fortunately, several years ago, the SEC fine-tuned some of the rules in order to grant what’s called risk-based, or “portfolio” margin.
When you’re granted portfolio margin, the funds you’re required to allocate to your positions are no longer based on individual trade risk, but rather on total position risk. Said another way, if you make a trade that partially or wholly offsets your risk in another one of your trades, you may only have to put up enough funds to cover the net risk, as opposed to the sum of the individual risks. Consider the following:
Suppose XYZ stock is currently trading for $100 per share. In order to purchase 100 shares of XYZ with a cash account, you’d need $10,000. However, using a standard margin of 50% (putting up 50% of the total cost of buying a stock), would require $5,000, while you borrow the remaining $5,000. There is some interest tied to the amount of money you’re lent, but it’s far less than the $5,000 that your position would otherwise require. Should the value of XYZ drop significantly, you may be asked to deposit more funds via a margin call.
Pretty straightforward, right? You pay according to your position risk. But now consider, in addition to buying 100 shares of XYZ stock, you also bought a 30-day XYZ 100-strike put for $3.00 (plus transaction costs). It would make sense that your total margin requirement would increase by $3.00, or $300 per contract. Hence, your total margin requirement would now be $5,300.
But let’s take a closer look at that position. The 100-strike put gives you the right to sell stock at $100 per share. Hence, for every cent you lose when XYZ drops below $100 per share, you make that up via real value in your put option. So, the only downside exposure you have is the premium that you paid for your put option, which in this case is $3.00, or $300 per contract plus transaction costs.
Traditional margin calculations would require you to put up $5,300. That’s $5,000 more than what you would have at risk during the life of your trade.
Now, if you’re approved for portfolio margin, you only have to put up the combined position risk, which in this case would be $300 plus interest. Essentially, this would leave you with more cash left from the combined stock/put position to initiate new positions. (However, if the put is sold or expires, the regular margin requirements on the stock kick back in.) Table 1 shows a summary of how your totals would be calculated. Not all calculations work as they do in this example, but as you can see, portfolio margins allow you to keep more of your cash. This cash can remain in your account generating interest, or it can be put to use in other trades. One caveat: you’ll need at least $125,000 to qualify for (and maintain) portfolio margining. So be sure to review TD Ameritrade’s margin rules before taking the plunge.
TABLE 1: PORTFOLIO MARGIN could provide more bang for your buck. But that leverage works both ways and you can lose money faster than you can say “margin call.” For illustrative purposes only.