Saturday, November 04, 2006

New Options for Traders

ONLINE BROKERS AND TRADERS ARE EXPECTED to be the first to employ newly revised margin requirements that can allow investors to take on more leverage. The new rules, which reflect options’ widespread acceptance, can significantly reduce the amount of cash an investor has to keep on hand to play the markets—provided his broker is willing and able to monitor the risks and the trader can demonstrate his ability to cope with the potential hazards.

Buying on margin, which means borrowing from a broker to buy securities, is a time-honored practice that allows investors to own shares without paying full-freight on every purchase.

Although there are a number of variations, all margin accounts have two essential features.

One is called the initial margin requirement, or the amount of money an investor has to put up to buy a particular security. Currently, this is 50% of the purchase price. Many brokers impose their own added requirements to protect themselves in case a loan goes bad; for example, Fidelity Investments requires customers to have a minimum account equity of $5,000 when placing orders on margin.

Once you have a particular security in your account, the second piece comes into play. You must meet maintenance guidelines that require an investor to keep a certain amount of equity in the account. The exact level is set by the securities exchanges and brokers who handled the transaction. Again, using Fidelity as an example, it wants customers to have either 30% of the market value of the holding in question, or $3 per share, whichever is greater. Each broker has the right to define its own requirements based on a customer’s profile as well as the kinds of securities held.

Margin requirements have typically not taken into account the effect of having an options position that hedges a stock holding. But the new rules do. They can be thought of as portfolio margining—taking into account all of a trader’s positions including options that offset the risk in a particular stock—rather than margining for individual trades as the existing rules mandate. Some think the new system, still being fine-tuned by the Securities and Exchange Commission staff and the exchanges, will cause a revolution in options trading. The revisions to what’s known as Regulation T are expected to take effect no later than the first quarter of 2007.

Foreign bourses already use the portfolio approach, which helps them attract active traders seeking leverage.

David Kalt, CEO and president of broker optionsXpress, provides an example of just how significant the change can be. Suppose an investor bought 1,000 shares of Microsoft for $27 each, or $27,000 in all. Under current rules, optionsXpress would loan you half the money, so you’d have to have at least $13,500 cash in your account.

But in the new setup, if you simultaneously bought January 25 puts, which give you the right to sell the stock for $25 up until the time the contract expires, you would only be required to cover the difference between $27 and $25, or $2 for each of the 1,000 shares, which is thought to be a more accurate reflection of your overall portfolio’s risk. So the investor would have to put up about $1,000 instead of $13,500. The new requirements may also allow an option on an index to offset an individual stock holding.

The new system won’t change Reg T guidelines, but will instead open up this portfolio-margining alternative to certain investors, says Doug Engmann, chief executive officer of broker Fimat Preferred. These investors must be deemed qualified by the broker to trade uncovered calls and puts—an extremely risky form of trading. As a result, the investor will need to thoroughly understand how options are written. And because participants will be putting up less money to trade similar-sized positions, they are subjecting themselves to greater possible losses.

“The whole idea behind the program is that it is designed so that experienced options traders who understand the risk in options trading are the only ones eligible to use the extra leverage,” Engmann says.

Not every broker will want—or be able—to offer the revised margins. It will require the analytical skill and technological capability to assess a trader’s margin requirements in real time. “You have to have really good risk management,” says Engmann. His firm will require “an interview with the customer to give them this level of margining.” And accounts taking advantage of portfolio-margining rules will be monitored separately from those using the more typical standards.

Only brokers with sophisticated computer systems that can be adapted quickly to comply with the new rules will be able to offer portfolio margining in the near future. Executives from thinkorswim, Interactive Brokers, optionsXpress and Fimat Preferred say they plan to utilize the new rules as soon as they are clearly defined.

Some would prefer to monitor the market’s progress for a bit. Randy Frederick, director of derivatives and corporate market data for Schwab’s Cybertrader, isn’t sure his firm will offer the program right away, “but I can say that if it makes sense, we’ll be involved.”

Published in Barron’s, October 30, 2006

Posted by twcarey on 11/04 at 02:40 PM
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