“Portfolio margin” is where brokerages will agree to evaluate the risk in a customer’s account by factoring together the offsetting directional risks of long and short positions. Under portfolio margin, by using spread trades a customer can take on far larger size and use more margin than they otherwise could if each of the various positions in a client’s account were evaluated for risk in a vacuum. Well constructed spread trades can increase consistency and decrease risk. This is the reason we want to develop an intuition for spread trade mechanics.
Let’s take a look at a very simple example: long QQQ and short SPY. The first chart shows that QQQ has outperformed SPY in the recent past, and you can see a spread opening up between the performance line for each. The second image shows the ratio chart for QQQ/SPY. The ratio chart is calculated by taking the QQQ share price and dividing by the SPY price for each point on the chart. We can see the ratio has risen from an average of around 0.35 to 0.5, a 43% increase.
At first blush, it would seem that we could capture this entire 43% move shown in the ratio chart simply by buying QQQ and shorting SPY. Unfortunately, it doesn’t work out that way. Let’s take a look at what actually will happen. The following chart is a rendering of a hypothetical portfolio that keeps QQQ at 100% of the value of the account, and SPY short at -100% of the value of the account. No transaction cost estimates are used.
This hypothetical portfolio returned only 36%, not the 43% we were hoping for. The good news is the largest drawdown was only 17% – one benefit we were hoping to see. QQQ and SPY each had a drawdown of 55% over the same time period, although they delivered triple digit returns.
The reason for the difference deserves some explanation. Consider this simple illustration of a hypothetical +10% day in both SPY and QQQ.
Starting account balance: $1,000
QQQ holding: $1,000 -> $1,100
SPY holding: -$1,000 -> -$1,100
At close, sell $100 QQQ, buy $100 SPY
QQQ holding: $1,000
SPY holding: $1,000
Ending account balance: $1,000
Our hypothetical account had a flat day, but the volatility forced some trades to happen to rebalance the account so that we could maintain the 100% long QQQ and -100% SPY positions. If you don’t make these rebalance trades periodically, you could face margin calls, or else not profit as much as you should for the position you intended. The chart above takes these rebalance trades every day at the open and again at the close. Now let’s introduce an estimate for transaction costs. Say we pay 0.25% of the value of every dollar amount traded. The following chart shows this new, much more realistic estimate of what we could expect.
Now we’re all the way down to 16% return, and this doesn’t even include the cost to borrow the SPY shares we are shorting, or the margin interest we would have to pay to the broker! Both of these fees will vary day to day, and are different across brokers, so we won’t dive into those things here, but there is something going on here worth calling out. The big reason for all of the trading expenses is the short position. Consider when it moves favorably. The value of our borrowed shares drops and we need to short more to maintain the -100% allocation. It is worse when it moves unfavorably! The value of the borrowed shares increases and we have to reduce the size of the position to maintain the -100% allocation (otherwise potentially face a margin call).
Finally, let’s render a hypothetical portfolio with the same 0.25% transaction cost estimate, but let’s concede to only rebalance on the first trading day of each week. As long as no margin call happens, the return pumps back up to 30%, with a largest drawdown of 18%. Not a very good return for ten years time and all the work to do the rebalancing, but now we have an intuitive understanding of the mechanics of a simple spread trade.