Portfolio margin: Basic hedging strategies

There are a few key concepts investors may want to be familiar with before getting started with portfolio margin. In this article we will discuss the basics of portfolio margin and hedging strategies investors may want to consider as part of your investment strategy.

The premise behind portfolio margin is to reward customers who use various stock and options strategies to reduce risk in their portfolio and reduce margin requirements. While Federal Reserve Board’s Regulation T (Reg T) margin typically adds up the margin requirements of each individual position portfolio margin adds up your total risk and uses that value to offset your margin requirements (Note: Reg T margin does not apply to Portfolio margin).

While any position can be hedged by the appropriate strategy, we’ll focus on long and short stock positions, as they are the most common positions in customer portfolios.

Long stock positions lose money when the stock drops in value. In order to help offset the downside, you can combine holding a long stock position with a position that profits while the stock drops in value. One such position is a long put. To illustrate this strategy, let’s explore the following example.

Let’s say you buy 100 shares of XYZ stock currently trading at $110 per share. Your maximum potential loss would be $110 x 100 = $11,000. To offset the downside of this position, you could buy a 110-strike put option. This gives you the right to sell your stock at $110 per share should you need to do so.

So, if you just owned the put option and the stock dropped to $100 per share, you could exercise your right to sell the stock for $10 higher at $110 per share, where the stock used to trade. Now suppose that option is trading for $2. You could then turn around and buy the stock back at the market price of $100 and generate a gain of $10, less the $2 you paid for the put option, netting a profit of $8. Note that this example does not include commissions and fees. Let’s now combine the two positions. If you bought the stock for $110 per share and you bought the 110-strike put for $2, your total risk would be reduced by the $2 you paid for the put option. The reason is that while every dollar that the stock price dropped would represent a loss to your portfolio, the loss would be made up by the gains from your long put option, less any applicable commissions or fees.

To continue on this example, if the stock dropped from $110 per share to $100 per share, your stock would show a loss of $10 per share and your 110-strike put would show a net gain of $10 per share. This would normally offset your stock loss, but remember you paid $2 for the option to begin with, so that would become your maximum loss per share.

Either way, the total loss of this combined put and stock position, also called a married put, is considerably less than that of the stock position alone. Hence, a long put position serves as a hedge for a long stock position.

Short stock positions lose money when the stock rises in value. In order to offset the potential loss, you can combine the short stock position with a position that profits when the stock rises. One such position is a long call.

For example, say you sell short 100 shares of XYZ stock currently trading at $100 per share. The maximum loss is theoretically infinite. To hedge, you could buy a 100-strike call option currently trading for $2. This gives you the right to buy stock for $100 per share should you need to do so.

So, if you only owned the call option and the stock rose to $110 per share, you could exercise your right to buy the stock at $100 per share, where the stock used to trade. You could then turn around and sell the stock at the market price of $110, and generate a gain of $10, less the $2 you paid for the option, netting a profit of $8.

Let’s now combine the two positions. If you sold the stock at $100 per share and you bought the 100-strike call for $2, your total risk would be reduced by the $2 you paid for the call option. The reason is that while every dollar that the stock price rose above $100 would represent a loss to your portfolio, this loss would be made up by the gains from your long call option, less any commissions or fees.

To continue on this example, if the stock rose from $100 per share to $110 per share, your stock would show a loss of $10 per share. Your 100-strike call would show a net gain of $10 per share. This would normally offset your stock loss but remember you paid $2 for the option to begin with, so $2 would become your maximum loss per share.

Either way, note that the total loss of this combined long call and short stock position is considerably less than that of the stock position alone. Hence, a long call position serves as a hedge for a short stock position.

Examples in this article are for hypothetical purposes only and not a recommendation.