Give me a lever long enough and a place to stand and I will move the entire Earth
– Archimedes
Options Sage submits:
Virtual Portfolio Margin – The Dawn of a New Era
On April 2, 2007 new rules for expanded virtual portfolio margin will come into effect, which are likely to have considerable impact on the way stocks and options are currently traded. Before we cover the nuances, let’s first examine the impact of margin in our trading accounts.
Whether you examine the property virtual portfolio of a real estate tycoon or the virtual portfolio of a successful private equity company, you will find a common thread that magnifies returns for each… leverage! It is no different in the stock market. In fact, each of us who trades options takes advantage of the leverage they afford us every day.
2. You CANNOT use margin to purchase options but there are MARGIN REQUIREMENTS for certain spread positions that we like to take.
Stock Buying Power: $200,000
Option Buying Power: $100,000
The benefit of margin is obvious but it doesn’t come without drawbacks. Had the stock dropped by 50% from $100 to $50, the $200,000 would have turned into $100,000 and since $100,000 was borrowed, the broker will issue a margin call and take back its $100,000 leaving us with $0! Hence, both the risks and rewards are magnified if we fully use margin under the current system.
You can readily see that for the broker to lend us money to trade options would be a very high risk venture on their part since the options can move by such huge percentages each day and your broker is only in the business of issuing margin in order to benefit from the interest you are paying.
Interest Charged on Margin Balances
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$0 – $49,999 8.75% -
$50,000 – $99,999 7.75%
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$100,000 – $249,999 7.50%
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$250,000 – $499,999 7.25%
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$500,00 – $999,999 7.00%
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Over $1,000,000 6.50%
This is critical information to be aware of. If you are not completely confident that you can generate a return greater than 8.75% on a borrowed capital less than $50,000 or 7.25% for example, on borrowed capital of $250,000 – $499,999 then margin is not yet a prudent choice. However, once you have proven to yourself that you can consistently and competently generate returns of greater than 8.75% then it is a smart decision to exploit margin as fully as possible. Just like the real estate tycoon or the corporate raider, we too can magnify our returns using borrowed capital.
Margin Debt
In 1929, the stock market crash was blamed on extensive speculation and excessive leverage, including margin buying. Following a crisis in the financial industry that left failed brokerages and devastated investors in its wake, the Federal government created the Securities and Exchange Act of 1934, separating the banking and securities industry, and giving the Federal Reserve Board the authority to set margin requirements, which it subsequently did through Regulation T.
The dangers of margin can be seen in this article “The Fear At The Margin”
The new formulas are designed to more accurately assess an investor’s risk by putting all of the positions in the same underlying stock in one virtual portfolio and then stress-testing that virtual portfolio for a 15% move higher or lower in the stock.
This makes much more sense when you think about the risk you actually assume in your virtual portfolio on certain positions.
Protective Put Risk = Total Cost Basis – Long Put Strike
Total Cost Basis = $96.55 + $6.90 = $103.45
Risk = $103.45 – $95 = $8.45
So, our virtual portfolio margin requirement is approximately $845 assuming a 100 share purchase and 1 long put contract purchase.
That’s a $10,345 investment that only has an $845 virtual portfolio margin requirement!
The power of this is really evident by interpolating to bigger numbers. A $103,450 investment has simply an $8,450 virtual portfolio requirement!
The Chicago Board Options Exchange (CBOE) have listed a number of different strategy examples and their accompanying virtual portfolio margin requirements here.
Some are listed below:
These are samples NOT recommendations!
COVERED WRITE
- Long 500 IBM @ $91.25
- Short 5 calls IBM APR 95 @ $ 2.78
Current margin is 50% of stock less the short option premium or $21,422.50 – new virtual portfolio margin requirement is $5,504.00.
PROTECTIVE PUT
- Long 500 IBM @ $91.25
- Long 5 puts IBM APR 90 @ $ 2.50
Current margin is 50% of stock plus full payment for put or $24,062.50 – new virtual portfolio margin requirement is $1,878.003
DEBIT SPREAD
· Long 50 calls IBM APR 90 @ $5.45
o Short 50 calls IBM APR 100 @ $ 1.16
Current margin requires full payment or $21,450.00 – new virtual portfolio margin requirement is $19,089.00
NON-CONFORMING DEBIT SPREAD (Long must expire on or after short)
- Long 50 calls IBM APR 90 @ $5.45
- Short 50 calls IBM JUL 100 @ $2.28
- Short 50 calls IBM JUL 100 @ $2.28
Current margin requires full payment for long option and appropriate margin on short option position or $74,750.00 – virtual portfolio margin requirement is $14,106.00!
LONG CONDOR
· Long 50 calls IBM APR 85 @ $8.99
o Short 50 calls IBM APR 90 @ $5.45
· Long 50 calls IBM APR 100 @ $1.16
o Short 50 calls IBM APR 95 @ $2.78
Current margin requires full payment or $9,600.00 – new virtual portfolio margin requirement is $6,221.00.
NON-CONFORMING LONG CONDOR (All options must expire at same time)
· Long 50 calls IBM APR 85 @ $8.99
o Short 50 calls IBM JUL 90 @ $6.82
· Long 50 calls IBM APR 100 @ $1.16
- Short 50 calls IBM JUL 95 @ $4.12
Current margin requires full payment for long options and appropriate margin on short option positions or $214,500.00 – new virtual portfolio margin requirement is $ 4,638.00! That is $209,862.00 less!!!
Does My Broker Offer Virtual Portfolio Margin?
I checked in with OptionsXpress and here’s what they had to say:
"At this time our target date for availability is early April 2007.
"We intend to make virtual portfolio margin available to as broad a group of customers as possible.
"However, because of the leverage that virtual portfolio margin allows customers to utilize, we will likely implement a minimum equity requirement for customers to be able to use this feature.
"In our continued commitment to education we are planning a number of educational events, such as webinars, to help our customers understand how virtual portfolio margin works and can be used in accounts.”
If you are using other brokerage firms I would highly encourage you to contact them to determine if they are also planning on offering virtual portfolio margin. We would also appreciate it if you used this post to give us feedback and we will do our best to compile an extensive list of practices as various brokers release their policies.
Impact of Virtual Portfolio Margin
While the impact of virtual portfolio margin is still to be fully determined, I suspect that a likely result will be an increased demand for longer term long put options. By purchasing relatively inexpensive (on a per day basis) longer term long put options, traders can now fully protect their stocks with minimal virtual portfolio margin requirements. Trades that originally seemed conservative, such as our KMP trade, become increasingly attractive as we can not only hold a low risk position but also benefit from the cumulative effect of short call premiums on a regular basis.
It wouldn’t surprise me to see short call premiums contract also as hedge funds leverage heavily to sell premiums in overwhelming numbers. Furthermore, I expect that Bid-Ask spreads may contract (this may be more noticeable on longer term options where spreads are often wider than shorter term options) as increasing contract volumes are traded.
My bet is the real winner in all this is not just the sophisticated trader but also the brokerages that offer the best service and executions. For me, that’s going to be OptionsXpress. Closing down $0.25 on Friday at $23.54 and with a PEG of just 0.71, attractive profit margins of 38%, operating margins of 66% and venturing into Europe now, I expect the risk/reward ratio favors reward. OptionsXpress does trade at a higher multiple than some competitors such as E*Trade and TradeStation but, in my view, it is warranted based on a superior platform, execution speed, customer service and forward looking earnings estimates.
With the stock trading much closer to support than resistance I’d be happy picking it up at these levels though some Jan09 long calls might be an alternative if you are not inclined to spend that level of capital on the stock. One thing to watch out for in the near future is earnings coming up between April 16-26 according to earnings.com. Getting in ahead of the announcement without hedging would only be appropriate for the more aggressive investor as anything can happen at earnings!
Phil’s play on this stock is the OXPS Jan ’08 $30s for $1.15 ahead of earnings, looking to roll into the ’09s after direction is set. Once we can utilize the new margin rules, Phil wants to buy 1,000 shares for $23,500 and to take 10 Jan ’09 $20 puts for $2,350 – reducing the margin requirement on the shares to $3,500 (the most that can be lost before triggering the puts), putting us in 1,000 shares while tying up just $5,850 in buying power. With this $5,850 investment, the next move is to sell 10 May $25s for .70, netting $700 (12%) in our first 46 days of ownership.
If we are "unlucky" enough to get called away, we will do so with a profit of $2,200 ($1,500 for selling the 1,000 shares at $25 plus the $700 from the contracts sold) less the change in value of the long puts, which would have to drop to almost zero for us to take a loss – not a bad risk/reward!
We will be taking full advantage of this brave new world of trading as the brokerages come on-line with new policies and products that allow us to make sensible use of maximum leverage. We may not be able to move the entire Earth but I think we can have quite an impact on your virtual portfolio!
Have a fantastic week!
Options Sage