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How Portfolio Margin can Increase Leverage by 15X

Posted by Jack Duval

May 2, 2014 6:28:27 AM

This blog post continues our series on Portfolio Margin.

As we have discussed here, Portfolio Margining calculates the margin requirement for all positions related to an underlying equity or index.  This approach is risk-based because it considers the effects of positions that hedge each other.  A simple example, which will be examined below, is how a long stock position can be hedged by a long put on that stock.

The risk-based approach of Portfolio Margin is distinct from the traditional Regulation T (“Reg. T”) approach to initial margin.  Reg. T considers each position as discrete for margin requirements, irrespective of any potential hedging that may arise.  Risk-based Portfolio Margin is based on the net of all the estimated gains and losses in the portfolio derived from stress tests on a common underlying equity or index.

Stress Tests

A typical stress test is to consider the potential gains and losses in the combined stock and options positions in an underlying equity.   A common test is to examine how much the combined positions would move if the underlying equity had a plus or minus 15 percent move. The biggest net loss after combining the profit/loss of all the positions over the plus or minus 15 percent range would be the new margin for the securities related to that underlying equity.

Married Put Example

In this example, we compare the margin requirements under Reg. T and Portfolio Margin. Here we assume the following:

  • Purchase 1,000 shares of IBM at $190;
  • Purchase 10 IBM July 14 190 Puts at $6.5;

 

Security

Number

Price

Position Value

Initial Reg T Margin

IBM

1,000

190

190,000

(95,000)

IBM July 14 190 Puts

10

6.5

6,500

(6,500)

                                             Total Ret. T. Margin:   (101,500)

Security

Number

Price

Position Value

+/- 15% Stress Test

IBM

1,000

190

190,000

(28,500)

IBM July 14 190 Puts

10

6.5

6,500

21,700

                                        Total Portfolio Margin:   (6,800)

Explanation

Under Reg. T initial margin requirements, the stock and option position margins are calculated separately and then added to each other.  This results in a total strategy based margin requirement of $101,500.

Under Portfolio Margin, both positions are aggregated and the plus or minus 15 percent stress test is applied.  In the married put scenario, the maximum loss occurs if the stock dropped 15 percent. The $28,500 loss in the stock would be offset by the $21,700 (estimated) gain in the put.  The difference, $6,800, is the Portfolio Margin requirement.

In the married put example, a hedge fund (or other investor) is able to increase their leverage by approximately 15 times using Portfolio Margin.

Variation in Portfolio Margin

Portfolio margin varies from strategy to strategy and will increase with the amount of market exposure in the combined positions.  In the married put example the market exposure is low because the put is at-the-money, however, if the position was collared at plus or minus 10 percent, the exposure would be higher and so would the Portfolio Margin requirement.

Furthermore, the broker-dealer providing the Portfolio Margin may also impose their own house limits that are higher that the Portfolio Margin limits.  This is similar to house maintenance calls that are triggered before Reg. T calls.

In our next post in the series, we will examine the Portfolio Margin requirements for different strategies.

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For more information about Accelerant expert Doug Engmann, go here.

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Topics: leverage, Margin, Portfolio Margin

Understanding Portfolio Margin

Posted by Jack Duval

Feb 11, 2014 9:56:11 AM

This blog post begins a series about Portfolio Margin.

Background

Listed options trading was initiated on the Chicago Board Options Exchange (“CBOE”) in 1973 after a long approval process through the Securities and Exchange Commission ("SEC"). With listed options, investors had the opportunity to hedge underlying equity positions with an exchange traded product that could be carried in a brokerage account. In the early years of options trading, margins for both public investors as well as professional options market makers and specialists were treated similarly, based upon the individual positions of the options themselves rather than the overall relationships between the options positions and their underlying equities.

Risk-Based Haircuts

In the late 1980s, under pressure from the CBOE and the other options exchanges, the SEC approved a pilot project to test the efficacy of using "risk-based haircuts" ("RBHs") as the basis for calculating how much capital a professional options market maker needed to carry his or her portfolio of options and underlying equity positions in any given class of security.  Risk-based haircuts are based on the principle that positions which hedge the risk in other related positions in a given portfolio ought to be given credit when calculating the margin or capital requirement for that portfolio.

Sage Clearing Corporation was the options market maker firm selected to participate in the pilot because it was the only options firm calculating risk on a real-time basis at that time.[1]  After months of testing, the SEC approved RBHs for market-makers in 1990. 

Public Investors

While options market makers received the margin and capital relief for RBH in the early 1990s, public investors continued to be subject to margin requirements which looked upon their options and equities positions separately, irrespective of hedging.  These margin rules were modified over the years to grant limited, but not total, margin relief for certain strategies.  Similar to RBHs, these modifications took into account offsetting positions in options or between options and their underlying equities.

Portfolio Margin

Under pressure again from the CBOE and the options exchanges, the SEC agreed to allow another pilot project in 2005 to grant margin relief to sophisticated options investors and traders who carried offsetting options and equity positions.  These rules were similar to the RBH rules for options market makers. The SEC named this alternative margin regime "Portfolio Margining".

FIMAT Preferred was the only brokerage firm testing portfolio margin for the SEC from 2005 until 2007.[2] Subsequent to 2007, the pilot was converted to a final rule and currently a few dozen firms have qualified to offer portfolio margin to their customers.

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For more information about Accelerant expert Doug Engmann, go here.

Notes

[1]           Accelerant expert Doug Engmann was co-founder and CEO of Sage at that time.

[2]           Accelerant expert Doug Engmann was CEO of FIMAT Preferred at that time.

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Topics: leverage, Margin, Portfolio Margin

Douglas Engmann Joins Accelerant LLC

Posted by Jack Duval

Feb 7, 2014 10:38:15 AM

Accelerant is pleased to announce the addition of Doug Engmann as a consultant and expert.  Doug has expertise in many aspects of broker-dealer lending, risk management, and oversight, including:

  • Portfolio margin
  • Hedge fund lending
  • Risk management
  • Portfolio liquidation
  • Derivatives and equities trading
  • Portfolio management
  • Clearing firm practices
  • Exchange and industry utility management

Doug is the President of Engmann Options Inc., a San Francisco private investment and securities consulting firm owned by the Engmann brothers, and Chairman of Sage Brokerage Holdings, the parent of a operating broker dealer servicing proprietary trading groups and hedge funds.

Mr. Engmann recently retired as Co-Chairman of Revere Data, LLC - a business intelligence and data company servicing the financial services industry. He was formerly the Senior Executive Vice President and Managing Director of Equities for Newedge USA, LLC (formerly Fimat USA), where he also served on the Fimat USA Executive Committee. Fimat USA had acquired the San Francisco based retail brokerage firm Preferred Trade (founded in 1982) from the Engmann brothers in 2005. At Fimat, he pioneered the use of portfolio margining under the pilot project approved by the SEC in 2005.  Fimat was the leading broker-dealer using portfolio margining for its hedge fund and institutional customers in 2007.

As an active participant in policy matters regarding securities and derivatives trading and processing, he has served:

  • As a board member of the National Securities Clearing Corporation
  • As a board member of the International Securities Clearing Corporation
  • As a board member of the Options Clearing Corporation
  • On the Securities Industry Association’s Options Committee
  • On the Pacific Exchange as a member of the Board of Governors, Vice-Chairman, and Acting Chairman
  • On the Risk Advisory Committee of the New York Portfolio Clearing (a joint venture between DTCC and the New York Stock Exchange

Doug has a Bachelors in Economics from University of California - Berkeley and a Masters in Economics from the Massachusetts Institute of Technology.

Doug will be associated with Accelerant’s New York City office.  Additional information about Doug can be found here.

Accelerant (http://www.accelerant.biz) is a securities litigation consulting firm specializing in large and complex cases. Our experts have industry, academic, and regulatory experience and bring broad and deep securities and regulatory knowledge as well as analytic rigor to their work.

Accelerant’s clients value our ability to communicate complex ideas simply, our reputation for unbiased, independent, and high quality analysis, and our commitment to a highly responsive work ethic. Headquartered in New York City, Accelerant also serves clients from our Hong Kong and London offices.


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Topics: hedge funds, Securities Expert, portfolio margining, Margin Sales, Doug Engmann, Margin

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