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The Margin Investor

Margin Rate Comparisons - The make or break factor for advanced trading strategies

5/14/2012

11 Comments

 
Today's topic of conversation is margin rates, that is, the rate your broker charges you on a margin loan. The margin rate can have a profound impact on an investor's overall return and may even be the make-or-break factor in determining whether a given trading strategy will be profitable. 
To illustrate, let's consider the following example: say we have a investment strategy designed to produce average annualized returns of 5%. While 5% may sound meager to some investors, imagine that our strategy is a highly risk controlled one that hedges out most of the risk of overall market fluctuations (this could be a long/short portfolio for example). Therefore, leveraging the strategy up to 4 to 1 is both feasible and prudent. So, without margin (i.e. using leverage) the portfolio produces 5% annualized returns, but at a leverage ratio of 4 to 1, the porftfolio produces returns of 20%. 

Sounds great, no?
margin ratecomparison
Margin Rates across various on-line brokers.
Alas, the story is never so simple. The missing piece here is that we need to deduct the cost of the margin loan from the portfolio's return. So, if our margin rate is say, 6%, then we will end up incurring a negative 1% loss for any leverage we take on (since it costs us 6% to make a return of 5%). Obviously, the cost of the margin loan negates the profitability of the trading strategy.

Now this is where it becomes interesting. The most indelible shift during the past 15 years in the brokerage industry has been the emergence of discount brokers, with their constant drive towards lower costs. Generally speaking, the effect this has had on commission structures has been to drive the entire industry towards similar commissions, as well as greater transparency on commission charges. While different discount brokers have different commission schedules, they are all within a competitive range.   
What's surprising is that the same cannot be said about margin rates. There is a huge range of margin rates across different discount brokers as is illustrated in exhibit 1 below.
Margin Rates for discount brokers
Exhibit 1. Margin rates as of May 1, 2012. Source: Interactive Active Brokers website.
Exhibit 1 isn't comprehensive by any stretch of the imagination, however, it does illustrate the point. Going back to our trading strategy described earlier, only Interactive Brokers, ETrade and Fidelity charges a margin rate that would make our strategy profitable. Moreover, the strategy with Etrade and Fidelity only becomes profitable if we have an account net equity value of 1.5 million or more.

What's the lesson here? Choose your broker wisely. The margin rate can be just as important (if not more important) than commission rates, execution, technology, or service.


11 Comments

Is Portfolio Margin Dangerous? Required reading for brokerage firm employees.

5/11/2012

15 Comments

 
I recently came across a highly insightful 2010 working paper out of the University of Sydney Business School entitled "Portfolio Margining: Strategy vs Risk" by E.G. Coffman, JR & D. Matsypura & V.G. Timkovsky.

The paper explores a number of different ideas including the riskiness of regular Reg-T margin versus Portfolio margin, the impact that the Portfolio Margin Pilot program may have had in terms of contributing to the stock market crash of October 2008, and the authors' belief that strategy-based margin has been unfairly discredited as a result of misinformation about the computational complexity of the strategy-based margining problem combined with the general bias towards heuristics by those (typically of the lawyer mindset) setting strategy-based margin rules.

Here is the abstract for the paper: 
This paper presents the results of a novel mathematical and experimental analysis of two approaches to margining customer accounts, strategy-based and risk-based. Building combinatorial models of hedging mechanisms of these approaches, we show that the strategy-based approach is, at this point, the most appropriate one for margining security portfolios in customer margin accounts, while the risk-based approach can work efficiently for margining only index portfolios in customer margin accounts and inventory portfolios of brokers. We also show that the application of the risk-based approach to security portfolios in customer margin accounts is very risky and can result in the pyramid of debt in the bullish market and the pyramid of loss in the bearish market. The results of this paper support the thesis that the use of the risk-based approach to margining customer accounts with positions in stocks and stock options since April 2007 influenced and triggered the U.S. stock market crash in October 2008. We also provide recommendations on ways to set appropriate margin requirements to help avoid such failures in the future.
The paper is quite advanced and may not be accessible to the average reader. However, for the technically inclined reader, the paper is definitely worth a read as it contains thought provoking examples of how Portfolio Margin can cause a pyramiding of debt under certain plausible market scenarios. 

So what does this all mean? Admittedly, not that much for the average investor. 
However, this paper and the concepts it contains should be read and mastered by anyone who works in margin and risk control at a brokerage firm. I applaud the authors for their work. 

For your conveniance, I've included a copy of the paper below.
15 Comments

Scott Sheridan (founder of thinkorswim) discusses Portfolio Margin on tastytrade

5/2/2012

3 Comments

 
The good folks at www.tastytrade.com have posted an interview with Scott Sheridan, the co-founder of thinkorswim (acquired by TD Ameritrade in 2009). The video discusses Portfolio Margin. I've embedded the video below. 

Informative? Honestly, not really. 
Unfortunately, the video is short on substance and long on ad-hoc commentary. While Scott is clearly articulate and knows his stuff, only the first six minutes of the video is really focused on portfolio margin. That said, I applaud the folks at tastytrade for continuing to produce useful and original videos for the trading community.   
3 Comments

    Author

    Jason Apolee is a contributing editor to The Margin Investor where he focuses on news commentary and evaluating broker offerings.

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