Investigating stress tested portfolio margin for Karen style positions

Thanks to the help from Tom of the Karen Study Group, I was able to set up my TOS paper account to portfolio margin and came up with the following initial understanding.

Karen uses a unique method to manage the allocated trading capital. She pretends the market dropping over 12% in her margin crash tests while TOS portfolio policy stated a minimal 10% drop for portfolio margin using broad index based vehicles. Using the TOS analyzer, she watches potential crash loss in the portfolio against the net liquidation value of her account as shown in the following picture. On the Analyzer tab, the daily P&L numbers at 10% up and 12% down must not exceed net liquidation value. 

In the above chart, the +6% and the -10% slices are broker SPX stress test prices. All the other slices beyond them are Karen’s stress test points. In order to maintain sufficient adjustment capital during market sell-offs, Karen lowers her stress test point below the 10% down point by another 100 to 200 offset points, depending on the long term market volatility condition.

• · 2013 Crash price (cushion) = (Current price – 100) x 88% due to lower volatility.
• · 2011 crash price = (current price – 200) x 88% due to higher volatility.

According to Figure 2: SPY and Its Implied Volatility Since 2008 shown before, there are 2 levels of IV in the past few years. Starting at January of 2013, the volatility made a lower low and stayed within a much narrow and lower channel ever since. Thus, it makes sense to use the smaller and pretended drop of 100 points of SPX in the crash price calculation starting at the beginning of 2013.

In my personal opinion, it will be a good time to switch to the larger drop of 200 points of SPX when the IV makes a higher low and forms a newly elevated channel in the future. If the volatility VIX is generally lower to a level of 11 and 12 at its bottom (this is a long bull market condition), the 100-point offset is used. If the volatility is higher to a level of 13 at the bottom of the VIX, the 200-point offset is used.

Additionally, it is easier in the TOS analyzer and more conservative if a Karen style trader uses the following formula to determine the crash price. Karen does not offer complete details of her trading system but encourages traders to come up with the system that they are comfortable with.

• ·         crash price = current price x 88% - 100 or 200

According to the statements in the interview, the 12% crash down price has a probability of ITM of 5% approximately. Let’s investigate it using today’s data as a specific example. The SPX price is 1900 on May 25, 2014. The 12% down SPX price based on Karen’s stress test formula is 1584. There is a 53 DTE July 1585 put option of ITM probability of 2%. Although the probability to expire ITM on July expiration date is quite low, the probability to touch the strike of 1585 is a bit higher, probably twice the amount of expiration probability to 4 to 10%.

Now, we can study the margin requirement and its changes for the hypothetical position shown in the above chart. It’s clear that the opening or initial margin requirement is $6,291. The “Explain Margin” section embedded in the chart indicates the margin requirement changes from -10% to +6% of SPX price changes.

However, if SPX drops to 1565, a level looked by Karen style trader, the loss would be $19,968. Karen would make sure the loss number is less than the net liquidation value of the account on the opening day with the proper size of contracts. This amount of the loss would be higher than the initial margin requirement of $6,291. As of today, I’m not sure what would the new margin requirement be in this scenario. Would it become 4.9 times of the initial margin requirement to $30,869? How margin requirement changes in market crash conditions still needs investigation in the future.

Although the PM requirement changes according to market conditions for existing portfolio and the changes may be different for various brokerage firms, the net liquidation value of an short option account is more deterministic. Therefore, the net liquidation value is used as the basis for comparing the daily P&L number in Karen style trading.

It should be noted that the initial margin $6,291 of the position is dictated by the short call option at an upside movement of +6% of SPX price as the down side movement of -10% requires a less amount of margin of $6,266 only. It implies more puts can be sold in trade adjustments if market tanks, because short put options require significant less margins. This is naturally helpful to obtain more credits to cover the deficit of put option rolling down or out when market crashes.