The Brave New World of Portfolio Margining

This column was originally published on RealMoney on April 4 at 12:15 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

It would probably not surprise most people that institutional investors or customers with more than $5 million in their trading accounts receive preferential treatment from their brokerage firms. One of the best benefits comes in the form of reduced margin requirements, or the amount of capital required to buy or sell equity-based financial products.

But it might surprise you that as of yesterday, these same lower margin requirements became available to most individual retail traders. Oh, your broker didn't tell you that your account is no longer bound by strategy-based margin requirements and now qualifies for portfolio margining rules?

While there are many details and some quite complex rules, the big difference is that strategy-based margining looks and charges each position as a separate entity. Portfolio margining, as the name suggests, looks at the entire portfolio, taking into consideration offsetting positions in calculating the charge of margin requirement.

Huge Reduction in Capital Required

"This is one of the biggest fundamental changes to occur in [the] brokerage business in years," says Randy Frederick, director of derivatives at Charles Schwab. He believes it will prove to be a huge benefit for those who incorporate options into their investing strategies.

To illustrate the magnitude of the reduction in capital that will be required, let's look at some basic offsetting positions and what likely will become the two most widely used strategies: married puts and covered calls. A married put consists of long stock and long a put option on that stock.

Assume one bought 1,000 shares of IBM at $97 per share and also purchased 10 of the April 95 put options. The margin requirement under the old rules would be $49,400. Under the portfolio margining rules, only $3,650, a 92% reduction in capital, is required to establish this position. For a covered call, that is, buying 1,000 shares of IBM and selling 10 of the April 100 calls, the margin goes from $47,000 down to $12,700, a 72% reduction.