What’s the Flux?

Penny Trading and Portfolio Margining Change Options Biz

The U.S. equities option market, which has grown at an annualized rate of 30 percent since 2000, has undergone a tremendous transformation. However, in many ways, this transformation has been just a rehearsal for what the options market faces this year. Clearly, the options market of 2007 looks very little like the options market of 1999, as the forces of electronification and institutionalization have entirely changed the players-and the profits. Now, the market is in the midst of absorbing two major regulatory changes that will significantly impact capital usage, transparency, liquidity and market structure. There’s also the possibility of new types of entrants participating in the marketplace. The penny pilot program and portfolio margining both stand to impact the options market in a profound way.

When combined, these forces are reminiscent of the equities market six years ago, when the penny pilot was first implemented in the U.S. equities market. While the options market and the equities market are quite different, there are similarities that they both share regarding how the markets’ structures will evolve in the context of the varied forces coming into play. The penny pilot has been widely discussed, and all of the exchanges have presented their findings, data and recommendations to the Securities and Exchange Commission. The market is now in the waiting room, anxiously pacing back and forth, awaiting the birth of what could possibly be an entirely new market structure.

Portfolio Margining

The other regulatory change, perhaps even more profound, has been the change effecting portfolio margining and creating a regime of risk-based margining for a wider swath of the market.

Portfolio margining will have a huge impact on the margin required in portfolios with stocks, ETFs and options. In some cases, it will decrease margin rates from 50 percent to 15 percent-not an insignificant reduction.

Different firms will handle the extent to which they will provide risk-based margining to different clients. Firms will also have different models, but as a starting point, the Theoretical Intermarket Margining System (TIMS) model developed by the Options Clearing Corp. will be the basis of many margining systems. Margin computations will look at equity and related options as a portfolio. TIMS analyzes the potential loss in a portfolio as a function of the moves in the underlying equity. Any options that act to offset that move will be reflected in the required margin.

The most basic example of the capital efficiency afforded to option investors/ traders under portfolio margining would be portfolio insurance. For example, say an investor buys 100 shares of IBM at US$105 and buys one October 105 put for US$5. Without portfolio margining, under traditional Reg T margin, the investor would be required to post 50 percent of the equity price (US$5,250) and 100 percent of the put cost (premium) (US$500) for a total Reg T margin US$5,750. Of course, the risk of this position would be minimal, as any downside in IBM is protected by the put option. Under risk-based margining, combining the maximum loss of 15 percent with the increase in put value yields a total margin of under US$500. The potential savings would be greater in complicated, multi-leg options trades. In many strategies, there could be capital reductions of 70 to 85 percent.

In addition to the added capital efficiencies that portfolio margining offers to options customers, it is important to keep in mind that until this change was made in early April of this year, it was only the market makers that were able to utilize a risk-based approach to margining. Hence, one of the additional impacts of portfolio margining is the ability for customers to trade in a freer capital regime, which was, until only recently, open exclusively to market makers.

Blur the Line

Portfolio margining will positively impact active traders and leveraged accounts. It will also continue to blur the line between certain types of market participants and market makers. Option market makers have operated in a risk-based margining regime. Now, a new class of traders will have a similar advantage. Portfolio margining, as it is phased in, will profoundly impact the growth of the options market in a very positive way.

The general retail investor will probably feel little impact from portfolio margining, as brokers will require certain minimum account sizes to help ensure that leverage is not put in the wrong hands. Likewise, asset managers will, in most cases, not leverage capital, and they often operate in a fully collateralized mode. However, certain asset managers will be offered significant flexibility in capital usage for synthetic products such as collars, for example. Active, sophisticated retail and proprietary shops, as well as smaller hedge funds, will see the greatest advantage under portfolio margining. But brokers will see portfolio margining as a mixed blessing: on the one hand, they will have to develop more sophisticated risk control and margin risk models; on the other hand, client volumes will increase. The largest, offshore hedge funds are probably already getting leverage beyond what they could get as U.S. domiciled funds.

Portfolio margining will put U.S. practices more in sync with risk-based margining practices in other nations, such as the United Kingdom. As we move into the second decade of this century, it should serve as a strong foundation to build both the options market and the U.S. securities market.

Market makers will benefit from the rise in volume that portfolio margining brings to the market, but will suffer from the margining equalization that portfolio margining brings to firms that could impact the economies of their business.

Generally, portfolio margining will require more sophisticated risk management tools for the broker-dealers offering risk-based margining to their clients.


The regulatory climate, with the introduction of decimalization through the penny pilot and during the last stages of portfolio margining, is quite profound, and it has implications for potential changes to the structure of the U.S. equity options market.

While the SEC is experimenting with penny trading, it might be interesting to see the expansion of dollar strikes in equity options, as many in the industry and at the exchanges see this as a means of increasing volumes. And though the reaction to portfolio margining has been quiet, this transformation will have a profound and lasting impact on the U.S. equity and index options businesses. Leveraged accounts and active individuals will see a significant improvement in capital efficiency in trading options. This factor will, undoubtedly, increase the volume of options traded.

Brad Bailey is a senior analyst at Aite Group, specializing in the coverage of electronic trading of equities, derivatives and institutional capital markets technology.