Calculating Margin for Leveraged ETFs
Margin calculation for most long positions is straightforward. On leveraged ETFs, however, the calculation is more complex.
Because leverage means 2x or 3x of the underlying, the "non-traditional" ETF is based on the degree of leverage. The maintenance level of 25% grow by the 2x or 3x levels. The levels required also vary based on whether your position is long or short. However, the margin requirement will not exceed 100% in any circumstances. The new rules:
If you buy shares of a 2x ETF, your old maintenance requirement was 25%. Under current rules, this goes up to 50%, or twice the old level (25% x 2).
Maintenance on 3x leverage changes from the previous level of 25% to the new level of 75% (25% x 3).
When you sell shares in a 2x, the previous level of 30% for short positions doubles to 60% (30% x 2).
The same rule is applied to 3x leverage. The previous level of 30% grows to a maintenance requirement of 90% (30% x 3).
Why the change? The action, which was initiated in December, 2009, is a response to the greater exposure associated with leverage. The Financial Industry Regulatory Authority (FINRA) explained at the time of the change, "In view of the increased volatility of leveraged ETFs compared to their non-leveraged counterparts, FINRA believes higher margin levels are necessary."
The new rules do not restrict trader rights to buy or sell leveraged ETFs. They do increase the capital requirements, resulting in lowering the degree of leverage traders can employ. So those high-risk traders going short on 3x ETFs used to be able to put up only 30%, but now have to keep 90% of the basis on hand, for example.
This may end up as beneficial in the sense that risks are reduced. Remember, 3x does not apply only when prices move in the direction desired. It also accelerates losses in the other direction. This reality -- easily overlooked, especially by novice traders but, at times, by experienced traders as well -- is mitigated to a degree by the new rules. However, the experienced trader who understands market risk quite well is likely to resent the implication that new, more restrictive rules are necessary. Unless you want regulation to protect you from a big loss, the higher margin requirements limit the degree of market exposure.
One solution to offset higher margin is to limit activity to long positions, where margin is easier to digest. So instead of going short on a leveraged bullish ETF, you get better margin play by going long on a bearish one. In this way, if prices fall, the leveraged long position will act the same as the short, but for a lower margin requirement. In a 2x, it is only a 10% difference (50% for long versus 60% for short). But in a 3x, the long requirement is 60% versus 90% for short.
Traders have to be aware of the different margin requirements for leveraged trades, to avoid margin calls and to make the most of available capital. The big advantage of leveraged ETFs -- accelerated profit potential -- is restricted by the margin changes intended to reduce the risks of the other aspect of leverage, accelerated loss potential when markets move the wrong way.
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