Keeping Up With The Times
Starting in this business back in the mid 1990s, markets looked very different from today. Assets were quoted in fractions. Commissions were obscenely high. Technology at the retail level was just beginning to make access for self directed investors a reality. The world was on the cusp of a revolution and that was all about to change.
By 2001, markets had left behind the world for fraction-based quotations in favor of penny-based. Commissions were at unheard of low levels. Retail traders could enter, change and modify existing orders. The wall that had once kept individual investors from active market participation had, like the Berlin Wall, suddenly come down.
Fast forward to 2023. Markets are not only quoted in pennies, but order fills are often done at fractions of a penny thanks to high frequency trading firms. Equity commissions in most places are now zero. And the technology continues to make strides by leaps and bounds. It is amazing to compare where we were less than thirty years ago with where we are today. Yet, for all those changes, there are aspects of the industry stuck in the past. Areas that can and should be improved upon but remain neglected.
If you are a stock trader, you’re likely familiar with Reg T margin. In a nutshell, Reg T allows investors to put up half the notional value of the stock being traded. If you want to buy 100 shares of Tesla, the notional value of that is over $20,000. With margin, you only need $10,000 and you can borrow the other $10,000 from your brokerage firm.
For futures traders, there is a different type of margining system known as SPAN margin. Without getting into the complicated details, SPAN margin is a more risk-based system based on current market conditions and prices. The S&P 500 (/ES) is a futures contract with a notional value of just under $204,000. But if you want to buy or sell a contract, it costs less than $15,000 or about 7% of the notional value. In other words, the leverage provided by SPAN margin is substantial relative to Reg T.
There are those who would argue leverage is dangerous. In some cases, they are correct. There are examples where leverage was used recklessly and the consequences, as a result, were dire. However, the fact remains, those cases are outliers. For the most part, leverage is what allows companies and people to become profitable. To be sure, we can’t simply have anyone running around taking on massive amounts of leverage; however, we have the technology in place to do real time assessments of risk, designed to avoid a catastrophe.
Aside from margin rules, self directed retail investors also have to contend with what is known as the Pattern Day Trading rule (PDT). The PDT rule essentially states that if you have an account under $25,000 and you do more than three round trip trades (open and close a position) in a five business day period, your account will be suspended from opening trades for 90 days. That is one-quarter of the year.
Picture this scenario. An investor places a trade on Monday and by Friday they are up 10%. That’s a nice return in a short period of time. However, three other trades they placed on Monday have also been closed because they also profited. If the investor closes their winning trade on Friday, they will face a PDT violation and be suspended from opening any new positions for three months. Therefore, they hold the position until the following week at which point the gains have not only turned to losses, but substantial losses that wiped out all the prior week’s gains.
In the world of investing, that has made so many advancements in the past thirty years, it’s time we address systemic limitations that were once imposed by technology. It’s time we trust people to make their own decisions about risk because we can monitor, in real time, the implications of that risk. If we want to truly democratize investing, then we need to update the rules which currently hinder that advancement.
Special Projects writer Josh Fabian contributed to this article.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.