Being a snob is so last century. Especially in a trading context. Today, it’s about equality. Designer sneakers and super-high-tech sing-you-to-sleep watches for everyone who’s got the green. So what separates us retail traders from the pros? After all, we often trade the same strategies. We both have access to real-time data. We both have lightning-fast trade execution. In a word, we both have margin, which is nothing more than a difference in leverage.
Traditionally, for a given position in stocks and/or options, the professional trader usually has a lower margin requirement than a retail trader and thus, more leverage. The rationale for the retail trader’s higher margin requirement is that he or she doesn’t have the knowledge or ability to manage risk as skillfully as a pro. While that might have been true 10 years ago, retail traders are quickly closing the knowledge gap. That’s why “portfolio margin” was introduced in 2007 to let retail investors get closer to professional-grade margins.
RETAIL TRADERS ARE PEOPLE TOO
Portfolio margin (PM) calculates the margin requirements of strategies like long stock, short puts, straddles, etc., that can be applied to single accounts whose net liquidity exceeds $125,000 (a TD Ameritrade requirement). This criterion is different from a “regular” margin account. And there are rules—i.e., the Federal Reserve Board’s "Reg T"—that determine the margin requirements for positions in margin, cash, and IRA accounts. FINRA also applies strategy-based rules for margin, cash, and IRA accounts meaning each particular strategy has specific requirements. For example, the minimum to buy stock in a margin account is 50% of the value of the stock shares. To buy 100 shares of a $50 stock, for example, the Reg T margin requirement would be $2,500.
PM is different. With PM, the margin on the long stock would be based on what its largest theoretical loss would be if the stock rose or dropped 15%. That 15% is the minimum percent change for equities, but can be adjusted to a larger percent change if the risk of the stock or position warrants it. For example, a long stock position would have its largest loss over that +/- 15% range if the price dropped 15%. For the same long 100 shares of a $50 stock, a 15% drop would cause a $750 loss (15% x $5,000). So, the PM requirement would be $750. Portfolio margins are deter- mined by a “stress test,” where the theoretical profit or loss is calculated if and when the price of a stock or index drops or rises, and volatility drops and rises, by percentages determined by PM rules. The PM requirement is the largest theoretical loss across those various “stress test” scenarios. In some cases, the PM can be much lower than the Reg T margin.
PM might sound complicated. But it’s actually pretty straightforward. Rather than saying the margin requirement for a vertical in stock XYZ is $A, a short strangle is $B, a long stock and covered call are $C, PM evaluates all the positions together in its test. If some of the positions in XYZ have a theoretical profit when XYZ is down, they can offset theoretical losses on other positions in XYZ, and the PM requirement, as a result, can be lower. Having a lower margin requirement for a position may sound great. But it also means being able to put on more, or larger, positions in your account. The downside of that, of course, is the risk of loss will increase with the additional leverage. And that might not fit your trading or investing style. So, if your account is above that $125k threshold, and you’re thinking about applying for PM, you need to go toward it with both eyes open.
FINANCIAL DEMOCRACY: PM IN ACTION
Before getting into the dirty details of PM, you may be wondering how it all works. Let’s look at a couple of popular strategies and the difference between traditional margin and PM.
PM on a Short Put.
In the world of traditional margin, say you were to sell short a naked 120 put for $0.80 credit on XYZ stock trading at $125. The Reg T margin would be nearly $2,000. Yet, in a PM account, the margin would be approximately $1,350. Let’s break down how that’s calculated. For equities, the PM calculation theoretically moves the price of the stock up and down 15% and divides that range into 10 equidistant points. For each price point in that range of scenarios, PM calculates the position’s theoretical value, and determines the position’s profit or loss at those theoretical values. The largest theoretical loss across these scenarios is the PM requirement. So, with the price of the shares down 15%, from $125 to $106.25, the put would have its largest theoretical loss of $1,350—thus, the PM requirement.
Margin Recap on Short Put:
Reg T = $2,000
PM = $1,350
PM on a Covered Call.
How about a covered call with long stock and a short out-of-the-money call? Let’s say you want to buy 100 shares of a stock at $41.35, and short a 44 call at $0.35. In a margin account, the Reg T requirement would be 50% of the value of the stock—100 shares at $41.35 x 50%—minus the credit for selling the call. That’s $2,067.50 – $35 = $2,032.50. In a PM account, the loss when the stock is down 15% would be about $590. So, in a PM account, that would be the margin required to do that covered call.
Margin Recap on Covered Call:
Reg T = $2,032.50
PM = $590
CALCULATING PM BLINDFOLDED
The PM requirement for stock and equity option positions is based on the +/- 15% stress test. But for options in small-cap, broad-based indices like NDX, the PM requirement is based on a +/-10% stress test. And for options in large-cap, broad-based indices like SPX, the PM requirement is based on a -8%/+6% stress test. There are different percentage ranges because some products are historically less volatile, and thus less risky, than others. Diversified indices tend to have lower volatility than individual stocks. Also, if your account has most of its risk concentrated in a single stock, a larger percentage range is used to determine the PM requirement. (Note that TD Ameritrade reserves the ability to hold higher margin requirements based on internal risk metrics.)While it’s possible to calculate a Reg T margin for a simple position in your head, that’s not necessarily true for PM. Fortunately, you don’t have to. You can get an estimate of what the PM requirement might be for a position even if your account isn’t yet approved for PM. The Analyze tab on thinkorswim® lets you see the daily loss of a position across the range of PM percent changes in the underlying stock or index. That will give you an estimate of what the PM requirement might be.
For example, suppose you’re looking to short a put on the SPX in a PM account. You can use the Analyze page to simulate a short SPX put. Referring to Figure 1, set the price slices on the Risk Profile to -8%/+6% to see the range for the SPX price on the Risk Profile.
Then move your cursor between the -8%/+6% range to find the largest p/l loss possible for that day. PM could reduce the margin requirement of those short SPX puts because of the way the algorithm computes a maximum theoretical loss. PM thus can give you more flexibility in strategy, in addition to lower requirements.
THE 99%: WHO “QUALIFIES”?
So how do you get PM? First, you must have an account with a net liquidation value of at least $125,000. Now, you don’t have to close all your positions to have a PM account. You can simply have PM rules applied to an existing margin account (sorry, PM isn’t available for retirement accounts like IRAs). But your PM account needs to have at least $125K net liquidity for starters. Second, your account has to be approved for Level 3 trading (naked option selling). Last, take an online test—20 questions that explore risk and options strategies to let TD Ameritrade know you understand enough about trading to feel comfortable granting you PM. With PM, it’s possible to put on large positions whose maximum risk is much greater than the value of your account. If a loss of that magnitude happens, it’s bad for everyone. And that’s why PM isn’t for everyone.
Now that you have a better idea of how PM works, is it right for you? Just because you have a PM account doesn’t mean you have to put on larger, or even more, trades. You naturally have the extra capacity to do so. But there’s no obligation. In that sense, having PM doesn’t hurt. And it may even be useful someday. So, take a look at your portfolio and trading styles. PM may give you some advantages you previously overlooked. And if it’s a tool you find beneficial over time, send the Founding Fathers a huge dividend check. Freedom for all means pro traders no longer get to hog the good stuff.