The great stock market crash of 1929 was blamed on rampant speculation, excessive leverage, and inadequate regulatory oversight. The debacle caused a wave of bank and brokerage failures that devastated the US financial system. Investors were left reeling. In order to restore confidence in the securities markets, the Federal government took several steps, including creating 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 [Reg T]. Now, almost 80 years after the crash, major changes to Reg T are underway.
Prior to the stock market crash of 1929, there was no limit on how much investors could borrow using shares. That, in turn, fueled a stock market bubble, as investors put up very little very capital but took on large positions of stocks at inflated prices.
Today, Federal Reserve rules establish a limit to how much investors can borrow to buy securities. These rules are embodied under Reg T, which requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities for buying stock on margin securities. For example, an investor borrowing on margin to buy $10,000 worth of stock is required to put up 50% collateral, or $5,000.
In the options world, the margin requirements are based on formulas for various strategies. Puts and calls that are bought (or long options) are paid for in full. To sell options, traders must put up 100% of the option proceeds and then a percentage of the value of the stock or index. Various spreads require a certain minimum margin that can vary from one strategy to the next. A straddle or strangle, which involves buying both puts and calls, requires the investor to pay for 100% of the cost of the options.
Critics of the current margin rules have argued that the current system does not create margin risk requirements that accurately reflect the true risk associated with certain strategies. For example, the protective put is a low risk strategy that involves buying shares of stock and also buying a put option, which effectively caps the losses from an adverse move in the share price. Yet, today, Reg T requires investors pay 50% for the stock and 100% the cost of the put option. Therefore, the margin requirement for establishing a protective put is actually greater than the margin for long stock, even though the risk from holding stock with a put is much less.
Under new rules that the Securities and Exchange Commission [SEC] approved in December and that go into effect on April 2, 2007, risk-based rather than strategy-based methodologies will be used to compute margin for some investors. The new formulas will more accurately gauge an investor’s risk by putting all of the positions in the same underlying stock in one portfolio and then stress-testing that portfolio for a potential (15%) move higher or lower in the stock. For instance, under the new rules, the margin is equal to the stock price plus the put option premium, minus the strike price of the put (the protection). The Chicago Board Options Exchange [CBOE] offers the following before and after example of the margin used on a stock and put position.
Long 500 IBM shares @ $91.25
Long 5 Puts IBM April 90 @ $2.50 a contact
Strategy-Based Margin (50% for stock and 100% for put) $24,062.50
Portfolio Margin (Stock price minus strike plus put price x 500) $1,875.00
The margin drops from $24,062.50 to $1,875.00! (For more examples and further information, please visit cboe.com/Institutional/Margin.aspx.)
While portfolio-margining will greatly reduce the capital required for certain positions such as protective puts, it also repeals Reg T on owning straight equities. This was somewhat of an unexpected outcome. Regardless, rather than putting up 50% margin for buying shares, the requirement drops to 15% (because the position is stress tested for a 15% move higher or lower in the stock.) Consequently, an investor can control $10,000 of stock with only $1,500!
Now, some critics might argue that Regulation T, which was the direct result of the market crash of 1929, is now null and void. In addition, the new rules could come into effect when margin debt is already quite high. According to a January 2, 2007 update in The Wall Street Journal,
“A rising stock market encouraged investors to go into debt to trade stocks, leading to an increase in the level of so-called margin debt in 2006... That 22% increase left margin debt not far from the record of $278.53 billion, reached in March 2000 as the Nasdaq Composite Index was setting a record high.”
Margin is already reaching the highs last seen during our most recent period of irrational exuberance in the stock market—the high technology bubble of 2000. So, is this a good time to repeal Reg T?
Fortunately (or unfortunately, depending on what side of the fence you’re on), portfolio-margining will not be available to all investors. Doug Engmann, Managing Director of Equities for Fimat USA, LLC, explains that only firms that have the “risk culture” to allow investors to actively trade options and use margin are preparing for the forthcoming changes. His firm has been an instrumental part of a three-phase pilot program that convinced regulators to embrace the new rules.
Moreover, Engmann explains that many firms do not have the tools for risk management or the existing technology to provide portfolio-margining. However, firms like Fimat USA have the experience and the technology due to the fact that the firm has cleared for market makers, which have used similar formulas to compute margin levels in the past. In addition, while the margin on stock purchases will come down, the new margin rules will encourage hedging, according to Engmann, which will serve to reduce risk.
Now that the rules have been approved, a couple of dozen firms are expected to join the fray. Prime brokers, or firms that deal mainly with institutional investors and other professionals, will be among the first to offer portfolio-margining. These firms stand to make a lot of money, not only by freeing up capital for their hedge fund clients, but also by generating additional revenues from margin interest and increasing trading activity. Options brokers such as ThinkorSwim and OptionXpress are also expected to offer the new margin requirements.
Fimat USA, LLC is the only firm currently offering these new margin levels [on certain products including broad-based indices and corresponding ETFs] to investors. However, the firm reviews customers on a case-by-case basis and requires a minimum account balance of $150,000 as well as Level 5 options approval, which includes approval to trade uncovered index option writing. Other firms will have their own rules and guidelines for allowing portfolio margining.
In conclusion, while risk-based requirements represent some of the most significant changes in margin regulation since the Great Depression, the process is not like flipping a switch and then, all of a sudden, all investors will have portfolio-margining available. For many stock investors, the changes will not be a factor at all. Many do not trade on margin and have sufficient equity already. They don’t need any more leverage. However, for short-term stock traders the added leverage can make big difference on profit and loss results. In addition, portfolio margin requirements will extend well beyond listed equities, but also include equity and equity options strategies; broad based index options; exchange-traded funds [ETF] and ETF options; and, perhaps one day, futures and futures options. However, due to time and space constraints, portfolio margining on those other products will be topics of discussion for a later time.
If you have any follow-up questions or suggestions, feel free to stop by my message board at optionetics.com and let me know.
Senior Writer & Strategist
Optionetics.com ~ Your Options Education Site
Visit Fred Ruffy’s Forum