Portfolio Margin Explained

Portfolio margin is a risk-based margining system designed to align margin requirements with the overall risk in a portfolio.

You should know that portfolio margin is intended for advanced traders only. It's not appropriate for everyone. We'll explain how the potential benefits of a portfolio margin account come with unique and significantly greater risks than cash accounts, as well as the potential for larger losses. Here's how it works.

The margin requirements for a portfolio margin account are set by an options theoretical pricing model using multiple pricing scenarios. These pricing scenarios are designed to measure the theoretical loss of the positions given changes to either the underlying security price or implied volatility inputs.

The investor benefits from portfolio margin because margin requirements calculated on net risk are generally lower than alternative strategy-based systems for determining margin requirements.

Lower margin requirements allow the investor more leverage in an account with the potential for greater returns but also the possibility of greater loss.

Let's explore what portfolio margin means and how it can potentially help you use your capital more efficiently by looking at some sample trades: a stock trade, a short strangle options trade, and finally a long put hedging example.

Along the way we'll also show you how to keep an eye on your margin requirements using the Analyze tab on thinkorswim^®.

When trading stocks with portfolio margin, margin requirements can be about half of those in a standard margin account. Say you want to purchase 100 shares of stock currently trading at $600 per share. In a standard margin account, the initial margin requirement would be 50%. You'd also then be held to the maintenance margin requirement, which is typically 30%.

So, in this example, $30,000 of margin is required to place the trade. The maintenance margin is $18,000.

In comparison, with portfolio margin, the margin requirement on an equity product would generally be 15% for both the initial and maintenance margin requirements.

In this example, that means the initial and maintenance margin requirements would each be $9,000.

There are several factors involved in determining the margin requirements in portfolio margin, but $9,000 is 30% of the standard initial margin requirement and half the standard maintenance requirement.

The additional buying power can be left in the account to act as a buffer to help support positions through periods of market volatility, it can be used for hedging purposes, or put towards other market opportunities.

Keep in mind, there are some unique requirements that come with portfolio margin.

For example, you must have at least $125,000 in equity to apply for portfolio margin approval. Once approved, your account is allowed to temporarily dip to $100,000. If a portfolio margin account settles the day below $100,000, the account would be restricted the following day to closing-only transactions due to FINRA regulations.

Also, with portfolio margin, concentration risk calls are handled differently than they are in Regulation T accounts.

Concentration risk calls occur when the firm determines an account has too much of a given security relative to its overall portfolio. To resolve a concentration risk call, you need to either add more funds or equities to the account or sell some of the concentrated position. In a Regulation T account, you might have a few days to resolve the concentration risk call, but in a portfolio margin account, a concentration risk call needs to be addressed the same day.

It's important to keep in mind that the risk parameters for portfolio margin can vary on a security-by-security, day-by-day, or even account-by-account basis. Given that portfolio margin determines capital requirements based on risk, securities of any product type with potentially high volatility may use a higher-risk parameter than standard margin.

This can happen over time as you place trades in the account, or it can happen in one risky trade. Finally, depending on the relative concentration and different positions in a given account, some accounts may use a higher risk parameter than others if their positions are more concentrated in a symbol or asset class.

To see how qualified options traders can utilize portfolio margin, let's look at a short strangle example.

A short strangle involves selling an out-of-the-money call and an out-of-the-money put with the same expiration on the same underlying stock. Typically, the strike prices are equidistant from the price of the underlying when the strategy is initiated. For this example, we'll sell a put and a call on company XYZ, each $40 out of the money, with over a month left until expiration. We're aiming for a credit of $34.50 per share, or $3,450 total. Because this strategy involves naked options, the standard margin requirement to sell one of these strangles could be around $12,000. But the requirement in a portfolio margin account would only be about $2,800. Here's why.

With portfolio margin, margin requirements are based on max losses. For context, when we say max loss, we mean maximum theoretical loss on the position over a one-day period. The maximum theoretical loss is based on an options pricing model that calculates the portfolio's theoretical gains and losses at different price levels.

So, in this example, the max loss as determined by the portfolio margining system is $28, or $2,800 for every single strangle sold.

Remember, max loss in this sense refers to the one-day loss at certain price movements. The actual max loss of this trade, and of strangles in general, is infinite.

Continuing with the example, that means in the portfolio margin-permissioned account, you'd potentially have $9,200 more in remaining buying power for every strangle sold. If you sold 20 strangles, that would add up to a margin requirement of $240,000 in a standard margin account, compared to a roughly $56,000 margin requirement in a portfolio margin account.

Again, this difference is because the standard margin account uses set percentages of stock and strike prices to generate the requirements for a naked options trade like a short strangle.

But in a portfolio margin account, margin requirements are determined using theoretical pricing models that measure the potential max loss over a one-day period at certain price levels. This amounts to less margin capital required per dollar traded than with standard margin.

Now let's look at a hedging example.

Portfolio margin can be helpful for hedging strategies. Because the margin requirements in a portfolio margin account are calculated in real time using pricing models to determine potential losses, it's important to monitor your portfolio risk.

The Analyze tab on thinkorswim is designed to make this easy. We'll illustrate using an example where we buy a stock, then buy a protective put to hedge the position to see how the margin requirement changes.

To start, select the Analyze tab on thinkorswim. Because of how fluid the margin requirement can be in a portfolio margin account, we encourage portfolio margin clients to use thinkorswim. When it comes to computing your margin requirements, there are multiple pricing models used, each with its own assumptions of how implied volatility may change at different price levels. Of the methods used, the risk array yielding the highest theoretical loss is applied for the margin requirement. By using the Analyze tab, all the guesswork about your margin requirements is removed because the risk array will show your requirements.

In this example, we're going to buy a stock position with a long put as a hedge using a demo account on thinkorswim with portfolio margin enabled. We'll start with a simulated trade of buying 100 shares of Apple, or AAPL. You can see what the margin requirements for this trade would be by looking at the section called Price Slices. The middle price, which is the live price, is showing what the margin requirement would be for this account if the trade is executed. If you select the box all the way to the right, the Explain Margin box appears. Here you can see what's called the risk array for the potential position. This allows you to see how the position might fare at different price levels. The risk array is broken up into different price intervals of up and down 3%, 6%, 9%, 12%, and 15%. So that's where your risk, and thus your margin requirement, is going to be held. For right now, at the price of Apple while recording this, that margin requirement would be $2,296.50 for 100 shares of Apple.

Now let's add the hedge of a long put against the 100 shares of Apple. For this example, we'll select the 150-strike put, which is about 30 days from expiration. Selecting that causes the put to appear at the bottom under Positions and Simulated Trades. With the put option in place, let's look at the new portfolio margin requirement. You can find that by looking at the middle row under Price Slices, all the way to the right. By adding the hedge, we've lowered the portfolio margin requirement quite a bit, to the mid 700s because the put could offset losses if the stock dropped.

Keep in mind that concentrated positions will be evaluated using a greater percentage price set by the firm due to excess leverage in a single underlying, resulting in a higher requirement than a nonconcentrated position.

On top of what we've already talked about related to risk and requirements, here are a few more ways portfolio margin differs from standard margin.

First, there's a portfolio-wide vega limit of 12.5% of the amount in your account available for liquidation. Vega refers to the rate of change of option price in response to changes in implied volatility of the underlying instrument. Portfolio-wide vega is the tally of the vega for every position in a given account.

To check where your account is with this, look at your account's total vega. Then multiply that number by eight, and the result needs to be under your net liquidation value.

Next, the portfolio margin debit-or-credit-cash-balance-versus-net-liquidated-value ratio limits the amount you can borrow. You can't borrow more than 15 times the amount in your account.

Let's look at an example. Say your account has $1,000,000 in net liquidation value. You'll want to make sure your cash balance, credit, or debit balance does not exceed either $15,000,000 or –$15,000,000. If your cash balance exceeds 15:1 as in this example, the account would be restricted to closing-only transactions. If your account hits 20:1, you'd be required to get back to 15:1 that day.

The firm may apply additional stress tests to portfolio margin accounts due to the increased leverage.

Finally, the firm's short unit stress test, which is a way of limiting the risk in portfolio margin accounts, is designed to prevent the accumulation of naked options outside the generally accepted risk parameters. The firm typically requires $1,000 of net liquidation value per net short index option, $200 of net liquidation value per net short equity options contract, and $500 of net liquidation value per net short volatility-related products.

Margin calls are also due sooner in portfolio margin accounts compared to Regulation T margin accounts and are strictly adhered to with no exceptions. Margin calls in portfolio margin accounts are due two days following a trade, at the latest, but may be due sooner based on market volatility and risk. You should also know that these requirements are subject to change based on market conditions.

Remember, the Analyze tab on thinkorswim is a great tool to stay on top of your margin requirements.

So, if you have a margin account with $125,000 in current equity, with full options trading approval, have three or more years of options trading experience, and the ability to pass a 20-question options test, you may be a candidate for portfolio margin.

Portfolio margin accounts can help increase your buying power, allowing you to invest more capital, potentially better weather market events, diversify your portfolio, and potentially yield greater returns.

It's important to remember that with the opportunity for greater returns also comes the risk of greater loss.