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.

Portfolio margining applies a real-time or actual risk to a position given a certain price move in the underlying security, as opposed to strategic margining, which treats each entity individually, explains Douglas Engmann, the Head of Equities for Fimat USA.

Fimat was a pioneer in portfolio margining, offering its hedge fund and high-net-worth customers an initial pilot program involving just index-based or broad exchange-traded funds. They found it to be an invaluable tool in capturing business from the "boutique" size investment firms, or those that have about $50 million under management.

"That was the sweet spot for us to gain open accounts," says Engmann, explaining that those firms are too small to command the preferential margins that the $500 million-plus funds get from their prime brokers, but they are also big, active and sophisticated enough to want to use the added leverage of portfolio margining.

Some of the key features of the new amended plan proposed by the Chicago Board of Options Exchange and the NYSE that were approved by the Securities Exchange Commission last December, but went into effect on April 2 include:
  • Removing the $5 million account minimum, but most brokers still can impose their own minimum account balances and trading experience thresholds. Brokers such as ThinkorSwim and OptionXpress will apply requirements, such as being allowed to sell naked or short uncovered options. Typically, that means about $100,000 and level five trading approval.
  • Portfolio margining will be expanded to include all equities and their related options, not just index products. It also will allow some cross margining of "highly correlated products." For example, options on the S&P 500 Index can be offset with options on the SPDR Trust (SPY). It will also include some similar futures contracts, and there will no longer be a need to have a separate cross-margining account.
  • Allows margin deficiencies to be resolved in three business days instead of the current one day. Won't that be great be when your margin clerk calls to tell him, "I'll get back to you in a few days"?
  • Brokerage firms will need to upgrade their margin-tracking systems -- implementing real-time monitoring of margin requirements, reconfiguring the stress tests or percentage moves from which margins are calculated, and initiating plenty of internal controls -- which must be approved by the NYSE, the Designated Examining Authority (DEA), before they can offer portfolio margining to their customers.

Big Headache

So while traders and the exchanges are excited about the ability to use capital more efficiently and what should result in a boost in trading volume, you can begin to understand why you didn't get a call from your broker saying you are now eligible to greatly reduce the capital requirements for trading.

Note that at this point only a handful of brokerage firms, such as OptionXpress and InterActive Brokers, have even submitted applications to offer portfolio margining their customers.

The calculations on switching from the current strategy-based to a risk-based formulas can become fairly complex and, frankly, are a big headache for these firms. The covered call and married puts examples are fairly straightforward, but when you get into more complex strategies, you need to start adding more variables and assumptions. Even a straightforward straddle, that is the simultaneous purchase or sale of both puts and calls on the same underlying security, will need to apply implied volatility to the margin calculation.

But once again, the capital requirement reduction will be substantial. For example, the purchase of a straddle in which one purchased 10 puts and 10 calls for a net debit of $5 had a margin requirement of the full $5,000 value of the straddle. Under the risk-based rules, the margin requirement will be about $750, assuming a 30% implied volatility.

This moves options and stock trading into the realm of commodities, and in many cases, will be even lower than the typical 20% margin requirement of futures contracts. I don't believe that too many brokers are thrilled with the prospect of giving all that leverage to their customers. It will be a lot of work keeping tabs on all that risk. But for those of you who qualify and believe you can handle the extra bang you can get for your buck, get on the phone and demand what's due to you.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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