Dec 29, 2016
By: Josh Fabian
From a young age, most of us are taught to equate risk with negativity. We are discouraged from taking risk because of potential negative consequences. Yes, when you risk you may lose. However, if you risk intelligently, you can minimize losses and leverage gains. This is true in business, life and in trading.
In the world of trading, risk and margin are too often considered synonymous. Margin allows a trader to increase the amount of capital with which they trade. Many people equate margin with, as an example, being able to purchase four hundred shares of ABC stock instead of one hundred shares. Using margin in that capacity is simply taking on more risk by becoming more correlated. It is not a smart risk. Intelligently using margin can reduce risk.
There are two types of margin available to investors and traders. First, there is regular ‘ole margin or T-3 if you want the technical term. With regular margin, traders must fund an account, on average, with $5,000 and are then required to come up with half the initial cost of a trade. Second, there is portfolio margin (PM). To use PM, accounts typically need at least $125,000 and margin is then calculated based on positions in an account:
On an individual trade basis, margin requirements can have substantial differences. Take for example selling a one standard deviation strangle in SPY. Currently, that trade will collect about $1.80 in credit. A regular margin account would be required to put up around $4,500 in capital to place this trade. Using PM, the margin requirement falls to just $1,600. Differences in requirements become even more pronounced when looking at an entire portfolio.
In a regular margin account, brokerage firms look at trades on an individual level when calculating margin requirements. Portfolio margin, on the other hand, takes all positions in an account into consideration. This allows for greater margin relief depending on position correlations. In other words, brokerage firms calculate requirements based on actual risk to the entire portfolio.
When an entire portfolio is viewed for its actual risk and requirements are reduced, a trader has more capital with which to work. That provides the ability to place more diversified trades. PM is how professional traders operate and it is what gives them an advantage. That is not to say trading with regular margin does not work. It does. PM simply gives a trader all the tools of the professionals. You can ride coach on a flight to Europe, but first class makes for a more comfortable flight.
Investors have two major themes from which they can choose when it comes to investing. We can choose a cautious passive approach; bench players at best, realistically, more like spectators. Or, we can actively take smart risks. We can get in the game. There are those who are happy to simply watch. tastytraders are not. We believe in ourselves. We believe our team has a better chance of winning with us on the court.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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