AT THE CLOSE
New Margin Rules (Part I)by J.L. Lord
April 2, 2007, the Securities and Exchange Commission (SEC) granted permission to the retail brokerage industry to adopt margin requirements in the style of those used by the Chicago Board Options Exchange (CBOE). For many investors, the new rules represent a significant addition to their purchasing power. It makes sense that these investors would want to know not only how they got the extra money, but what they are allowed to do with it.
WHAT IS MARGIN?
Whenever a trader initiates a trade, a broker will require money from that trader up front in order to help ensure that the winning party gets paid. That amount of money is referred to as a margin requirement.
The typical margin requirement for a stock purchase is 50% of the purchase price of the stock. For an investor looking to purchase 100 shares of Google, Inc. (GOOG), currently trading for $450 per share, the funds necessary to own this position would be:
The idea is that if GOOG loses half of its value, the broker has set aside enough funds to pay for his investor's loss.$450 (per share) x 50% x 100 shares = $22,500For a typical option trade, the margin requirement is simply the maximum risk in the position. For straight call or put option purchases, the margin is merely the initial debit of the position. There is no down payment or layaway alternative. You pay full price for ownership. For example, consider an investor who is looking to purchase the 450 strike put in GOOG. The put is currently trading for $10, or $1,000 per contract. Hence, in order to own this put option, you would have to surrender $1,000 to his broker.
As strategies get more complex, the margin requirements are fairly easy to calculate. As in most cases, it is simply the maximum risk of the position. Things get more involved with positions where maximum risk is excessive or unlimited (short puts, short calls, and so on).
WHAT DOES IT ALL MEAN?
These margin requirements have been in place for quite some time. While most investors take the requirements for granted, they serve as a constant hindrance for the educated investor. To illustrate, consider the following example:
A trader is looking to purchase 100 shares of GOOG, currently trading for $450 per share. Further, this investor also wants to purchase the $450 strike put in order to hedge against any downside exposure in his stock purchase. Note that the $450 strike put gives the investor the right but not the obligation to sell GOOG at $450 per share.
If this investor wanted to calculate his total cash outlay under the old margin rules, he would calculate it as follows:
First: Calculate the stock margin requirement
Take the total purchase price of the stock and divide it by two. This would give us $450/2 = $225. Take that and multiply it by the number of shares purchased. In this case, since you were looking to purchase 100 shares, you would multiply $225 x 100 and get a total figure of $22,500. This would be our total stock margin requirement.
Second: Calculate the option margin requirement
Take the total purchase price of the option and multiply it by the number of shares each option controls. In this case, one GOOG option contract controls 100 shares of stock. Therefore, we would multiply the price of the option by 100. Since the price of the $450 put was $10, our total option requirement would be 10 x 100 = $1,000.
Third: Sum up the total stock and option margin requirement
To obtain the total requirement for the position, the old rules dictate we have to add up all of these margin requirements. This means that our total margin for the combined stock and option position would be $22,500 + $1,000 = $23,500.
CHANGES UNDER THE NEW RULES
Under the new rules, traders are allowed to base their margin on the combined position risk. Therefore, rather than having two margin requirements for the two separate positions, under the new rules a trader will be able to obtain significant margin relief if one position does reduce the risk of another position. That alone is worth the price of admission! The retail trader now shares in power and privilege previously reserved for the most elite traders.
Hence, under the new rules, margin would be calculated as follows:
First: Calculate the combined maximum risk of the total position
It is true that 100 shares of GOOG trading for $450 per share carry a maximum risk of $45,000. It is also true that the purchase of the $450 strike put for $10 carries a maximum risk of $1,000. If these positions were held in separate accounts, they would translate into a total exposure of $46,000.
But the position is nowhere near as risky as initially considered. While you own a $450 stock, you own a put at the $450 strike. This means that although GOOG may at any time drop below $450 per share, by owning the put, you have the right to sell GOOG at $450. This negates downside exposure you previously had in the stock. Hence, the only exposure you would be responsible for on a downward move in the stock would be the $1,000 required to purchase the put option.
If GOOG decides to rise in value, you would benefit from the stock purchase. So once you make up the $1,000 investment required for the put purchase, the additional upside movement in the stock represents nothing but profit. The most you can lose is $1,000. Therefore, that is the total margin requirement under the new rules. Interest rates are another factor to consider under the new margin rules. This will be covered in the next part of the series.
As of this writing, although the new margin rules are SEC and NASD approved they are still being tested. Not all brokers are participating in the pilot program, and those who are doing so are only offering it to clients with $100,000 in their trading accounts.
J.L. Lord is an author and trader.
RELATED READING
Lord, J.L. [2007]. One Strategy For All Markets, Random Walk Trading.
Return to June 2007 Contents Originally published in the June 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.