Portfolio Margin Considerations with the Automated Backtester (Part 1)

I want to revisit something mentioned in Part 1 about portfolio margin (PM).

Allocation and margin are two separate things with regard to short premium trades and I have only been taking into account the former. I have mentioned allocation with regard to serial backtesting of [non-overlapping] trades. After further consideration, I think margin should be monitored because while we may be able to place a trade, whether we can maintain the position when the market goes sharply against us is a different story.

At some brokerages, accounts of sufficient size can qualify for portfolio (also termed “risk-based”) margin (PM). Reg T margin [which applies to cash, not margin, accounts] reduces buying power by the maximum potential loss at expiration for a given trade. PM uses an algorithm that analyzes profit and loss of the whole portfolio when stressed X% up and Y% down. In other words, if the underlying security were to increase (decrease) by X% (Y%) today (not at expiration), then the algorithm calculates the worst change in value across that range. Specifics vary by brokerage but as an example, the algorithm may calculate -12% and +12% by increments of 3%. The maximum loss at any increment is the portfolio margin requirement (PMR). I will not incur a margin call provided PMR is less than the net liquidation value of my account.

Calculating PMR requires modeling of the cumulative position. A permanent component of the option pricing equation is implied volatility (IV). IV may be understood as the relative supply/demand for an option. This is inherently unknown, which is why a model is necessary.

As an example to explain this price uncertainty, suppose I am an institutional option trader looking to allocate $50 billion to a specific short premium position. The sooner I get this done, the sooner I have the opportunity to start making daily profit. Once the funds clear, I want to be in regardless of whether the market is up, down, a little or a lot.* You can be sure my $50 billion is going to move some markets by making purchased (sold) options more (less) expensive along with a coincident IV increase (decrease). This is the principle of supply and demand that, in this case, has nothing to do with underlying market move: simply when the bank/brokerage clears my funds for trading. For this and countless other reasons having nothing to do with market movement, unpredictable purchases/sales regularly occur—perhaps in smaller dollar amounts but the aggregate effects can be imagined to be similar.

I will continue next time.

* I may avoid “a lot” if liquidity dries up or bid/ask spreads become large.