What is Portfolio Margin?
The word "margin" is often misunderstood by investors, but the concept of margin is really very simple and, what's more, it's one you probably already use: you're simply borrowing money to buy securities, which allows you greater buying power and, thus, greater returns.
If you've ever had a traditional mortgage, car loan or line of credit, then you've essentially used margin.
As the experts at Interactive Brokers aptly explain: "Borrowing money to purchase securities is known as 'buying on margin.' When an investor borrows money from his broker to buy a stock, he must open a margin account with his broker, sign a related agreement and abide by the broker's margin requirements. The loan in the account is collateralized by the investor's securities and cash. If the value of the stock drops too much, the investor must deposit more cash in his account, or sell a portion of the stock."
In our case, we're borrowing cheaply from Interactive Brokers to buy preeminent high-yield stocks and ETFs, including our core holdings, as well as capturing special dividends and taking advantage of momentum moves on stocks prior to their ex-dividend dates. Remember, these are the bluest of the blue chips, so we'll be buying steady, highly-vetted names with our portfolio margin.
Like any lending program, portfolio margin is only open to qualified borrowers, and there are requirements. Because Interactive Brokers is the broker of choice, I'll explain their conditions, but keep in mind that if you elect not to use Interactive Brokers, the terms will likely be different.
Don't Settle for the Regular
Regardless of broker, when you begin trading on margin, you will start with a Regulation T (Reg T) margin account. As the name implies, Regulation T margin is the baseline requirement for all investors to trade on margin.
Reg T accounts require a minimum of $2,000 or U.S. dollar equivalent of securities equity to open a new position (some brokers will impose their own conditions and will require as much as $5,000 of initial margin).
While you only need $2,000 to establish a Reg T account, you'll need a significantly larger account of at least $200,000 to mirror the kinds of returns I'm targeting.
Once an investor has started buying a stock on margin, the regulations require that a minimum amount of equity be maintained in the margin account which is called the maintenance margin. Investors must have at least 25% of the total market value of the securities they own in their margin account. Keep in mind that brokers may impose additional requirements for a Reg T account and may insist on 30% to 40% maintenance margin.
I'd like to review how this maintenance works for a Reg T account so that when we talk about a Portfolio Margin account later, you'll be able to note the differences and advantages of Interactive Brokers' Portfolio Margin accounts.
In a Reg T account, let's say you purchase $100,000 worth of securities by borrowing $50,000 from your firm and paying $50,000 in cash or securities. If the market value of the securities drops to $80,000, the equity in your account will fall to $30,000 ($80,000 - $50,000 = $30,000).
If the brokerage firm has the minimum 25% maintenance requirement, you must have $20,000 in equity in your account (25% of $80,000 = $20,000). In this case, you do have enough equity because the $30,000 in equity in your account is greater than the $20,000 maintenance requirement.
But if your firm has a maintenance requirement of 40%, you would not have enough equity. The firm would require you to have $32,000 in equity (40% of $80,000 = $32,000). Your $30,000 in equity is less than the firm's $32,000 maintenance requirement. As a result, the firm may issue you a "margin call," since the equity in your account has fallen $2,000 below the firm's maintenance requirement.
Now, as I've said, Reg T is the baseline margin account for any investor. But I'm not interested in acting within the limitations of any old investor; I want to give you the same power that hedge funds and the big money have, which is why we won't be using Reg T margin accounts but true Portfolio Margin accounts.
But because Portfolio Margin accounts offer special terms and advantages, Interactive Brokers requires a minimum account balance of $110,000. You should note that unfortunately, Portfolio Margin is not available to IB Canada clients, and if your account drops below $100,000 U.S., you will be restricted from executing any margin-increasing trades. Therefore, if you do not intend to maintain at least $100,000 U.S. in your account, you should not apply for a Portfolio Margin account. However, given that I want you to have at least $200,000 to allocate to this strategy, you should be well above that minimum.
The key difference between Reg T accounts and Portfolio Margin accounts is that while Reg T requires you have a set percentage of maintenance margin (25% to 40% depending on the brokerage), margin requirements in a Portfolio Margin account are theoretically much, much less because they are determined using a "risk-based" pricing model that calculates the largest potential loss of all positions in a product class or group across a range of underlying prices and volatilities.
Interactive Brokers uses a model called the Theoretical Intermarket Margining System ("TIMS"), which is applied each night to U.S. stocks, OCC stock and index options, and U.S. single stock futures positions by the federally-chartered Options Clearing Corporation ("OCC") and is disseminated by the OCC to participating brokerage firms each night. The minimum margin requirement in a Portfolio Margin account is static during the day because the OCC only disseminates the TIMS parameter requirements once per day.
The thesis is that margin requirements with a Portfolio Margin account will be lower because we are focusing on relatively low-risk, blue chip stocks, which translates to greater leverage. However, I need to note that there is also the possibility that, given a specific portfolio composed of positions considered as having higher risk, the requirement under Portfolio Margin may be higher than the requirement under Reg T.
Again, we hold lower-risk names, as well as hedges and maintaining a cushion of margin (i.e., we won't be maxing out our margin), and so the expectation (and my real-life experience as a professional fund manager) is that a Portfolio Margin account will mean significantly lower maintenance margin and, hence, much more buying power. We'll maintain a balanced, blue-chip strategy to not only keep our costs down but to diminish the possibility of a margin call.
In this environment, Interactive Brokers' unprecedented low lending rates of 1.67% and more judicious maintenance requirements in their Portfolio Margin accounts mean increased buying power for you and ultimately greater returns.
If you decide to open an account with Interactive Brokers, simply click on the button below, choose the ProTrack application, and begin the simple process of signing up. Additional note: During the ProTrack application process, check the box for "options" to enable an account for Portfolio Margin - the OCC/SEC will not let Interactive Brokers administer Portfolio Margin for accounts that are not approved for options, even if you do not intend to trade options.
InvestorPlace Media, LLC and Bryan Perry receive no compensation or direct financial benefit from Interactive Brokers.