Understanding Portfolio Margin

In the past, professional traders could expect lower margin requirements than retail traders. However, in 2007, portfolio margin was introduced as a way for retail traders to access leverage similar to their professional counterparts. Portfolio margin offers a way to calculate a trader's margin requirements based on the overall risk of their portfolio and the trade.

Portfolio margin can be applied in real time to approved Schwab accounts that have an initial minimum equity that exceeds $125,000. Portfolio margin (PM) uses an options pricing model to calculate the margin requirements of different strategies in an individual security—such as long stock, short puts, straddles, and others—as one aggregate position.

Traditional margin rules follow the Federal Reserve Board's Regulation T¹ (Reg T) when determining the margin requirements for positions in margin accounts. The Financial Industry Regulatory Authority (FINRA) also applies strategy-based rules for margin and cash accounts, meaning each strategy has specific requirements. For example, the minimum to buy stock in a margin account is generally 50% of the value of the stock shares. To buy 100 shares of a $50 stock, for example, the Reg T margin requirement would usually be $2,500.

When calculating PM, the margin on the long stock is 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 plus or minus 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 determined by a "stress test," where the theoretical profit or loss (P&L)² 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 on a risk array of price movement and percentages. In some cases, the PM real time can be much lower than the Reg T margin.

For example, the margin requirement for a vertical spread strategy in stock XYZ is $A, a short strangle is $B, and a long stock and covered call are $C. Under normal margin rules the total margin would be ($A + $B + $C). But under PM, all these positions would be assessed 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.

A lower margin requirement for a position allows a trader to add more, or larger, positions in their account. When using margin, though, the trader should understand that losses can potentially be bigger due to additional leverage. In addition, risk models used for portfolio margin may not account for all potential portfolio risks.

To calculate PM, an options pricing model focuses on the following inputs:

• Underlying price
• Strike price
• Time to expiration
• Volatility
• Risk-free interest rate
• Dividend yield

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 broad-based equity indexes like the S&P 500^® index (SPX) and the Nasdaq-100^® (NDX), the assessment range is down 12% to up 10%, and the range is divided into 20 equidistant points to capture more price moves on the risk array. Then, for each price point in that range of scenarios, PM calculates the position's theoretical value, and determines the position's P&L at those theoretical values. The largest theoretical loss across these scenarios is the PM requirement.

Below are some example strategies and how they work with portfolio margin.

For example, a trader could 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. The portfolio margin, on the other hand, would be approximately $1,350. If the price of the shares went down 15%, from $125 to $106.25, the put would have its largest theoretical loss of $1,350, and that's the PM requirement.

Margin recap on short put:
Reg T = $2,000
PM = $1,350

Next, let's look how portfolio margin might be calculated for a covered call with long stock and a short out-of-the-money call³.  A trader might 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 multiplied by 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. Therefore, that would be the margin required to do that covered call.

Margin recap on covered call:
Reg T = $2,032.50
PM = $590

While the PM requirement for stock and equity positions is based on the plus or minus 15% stress test, options in broad-based indexes like the NDX and SPX have a PM requirement based on a –10% or +12% stress test. Diversified indexes tend to have lower volatility than individual stocks, so the PM calculation is different.

Additionally, if an account has most of its risk concentrated in a single stock, a larger percentage range is used to determine the PM requirement. (Schwab reserves the ability to hold higher margin requirements based on internal risk metrics.)

The thinkorswim^® trading platform can calculate what the PM requirement might be for a position. The Analyze tab on thinkorswim lets traders review the daily loss of a position across the range of PM percent changes below or above in the underlying stock or index. That gives traders a real-time estimate of what the PM requirement might be.

For example, a trader might consider a short a put on the SPX in a PM account. They can use the Analyze tab to simulate a short SPX put by setting the price slices on the Risk Profile to see the range for the SPX price on the Risk Profile.

Moving the cursor between the –12% or +10% range helps the trader find the largest loss possible for that day. Using a PM calculation 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 traders more flexibility in strategy in addition to lower requirements.

To qualify for PM with Schwab, a trader must have an account with a net liquidation value of at least $125,000. It's possible to apply for PM for an existing margin account. Additionally, an account must be approved for Level 3 options trading (all options strategies including uncovered options selling⁴). Finally, a trader must take an online test. The test consists of 20 questions that explore risk and options strategies that allow Schwab to determine whether a trader is sufficiently knowledgeable to handle a higher degree of risk.

• To be eligible for portfolio margin, clients must be approved for writing uncovered options.
• A margin deficiency in the PM account or sub-account, regardless of whether due to new commitments or the effect of adverse market movements on existing positions, must be met within two business days or may be due immediately because of market volatility.
• Any shortfall in aggregate equity across accounts, when required, must be met within two business days.
• Portfolio margin generally permits greater leverage in an account, which can create greater losses in the event of adverse market movements.
• Because the maximum time limit for meeting a margin deficiency is shorter than in a standard margin account, there is increased risk that a client's portfolio margin account will be liquidated involuntarily, possibly causing losses to the client.

The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.