Portfolio Margin Considerations with the Automated Backtester (Part 3)

Today I continue discussion of portfolio margin (PM) [requirement (PMR)] and the automated backtester.

Please recall that I have described two research approaches. The first analyzes trades opened daily to collect statistics on the largest sample size possible. The second approach studies serial backtesting of non-overlapping trades to generate an account equity curve and to study things like maximum drawdown and risk-adjusted return. The latter lends itself to one sequence of trades out of an infinite number of potential permutations, which is suggestive of a Monte Carlo simulation.

I can definitely see a use for PMR calculations in the daily trades category. For each trade, the automated backtester could approximate PMR at trade inception and for each [subsequent] day in trade. To get a sense of how much capital would be required to maintain the position, we would want to track the maximum value of the subsequent/initial PMR ratio. The amount of capital needed to implement a trading strategy is at least [possibly much more if done conservatively as discussed here and here] the maximum value of the subsequent/initial PMR ratio observed across all backtested trades. In addition to this single number, I would be interested in seeing the ratio distribution of all trades plotted as a histogram and perhaps also as a graph with date on the x-axis, ratio on the left y-axis (scatter plot), and underlying price on the right y-axis (line graph).

PMR calculations might have a place in the serial trades category as well. Plotting equity curves of different allocation percentages is different from whether those portfolios could be maintained depending on max PMR relative to account value. If PMR exceeds account value, then at least some positions would have to be closed. Since it’s impossible to know which positions this would involve or even whether the broker would do it automatically (at random), I might assume a worst-case scenario where the account would be completely liquidated. On the graph, the equity curve would go horizontal at this point. With a consequence this drastic, I think PMR monitoring is worth doing.

In addition to PM, some brokerages have a concentration requirement. One brokerage, for example, looks at the account PnL with the underlying down 25%. The projected loss must be less than 3x the net liquidation value of the account. Violation of this criterion will result in a “concentration call,” which is akin to a margin call. An account can be in the former but not the latter if it holds DOTM positions that would (not) significantly change in value with the underlying down 25% (12%). Closing these options (typically for $0.30 or less) will often resolve the concentration call.

Building concentration logic might be useful for backtesting with filters. A large enough account could actually be traded by opening daily positions. Otherwise, implementation of filters could result in multiple open positions (albeit less than one new position per day). Stressing the whole portfolio by walking the chain up 25% would be useful because a strategy that looks good in backtesting but violates the concentration criterion is not viable. Put another way, I cannot project a 20% annual return on capital when the capital actually needed to maintain a strategy is quadruple (quite possible with PM) that projected. In this case, 5% annualized would be a more accurate estimate.