The word "power" has a lot of possible meanings, depending on the context. But at the top of the list, it's usually defined as "the ability to do something."
In the financial markets, the term "buying power" also refers to an ability to do something - specifically through financial means. In particular, it refers to the total amount of money an investor/trader has at their disposal to execute financial positions, and maintain them.
It should be noted that buying power is a term used in affiliation with an investment account, as opposed to an individual or a portfolio. That means that buying power is equal to the total cash in a given account, plus all available margin (i.e. credit) in the same account.
At tastytrade, we also use the term "buying power reduction" (aka BPR) quite often. BPR refers to the specific amount that our buying power will be reduced by in a given trade.
Buying Power Reduction is obviously important because it helps us better visualize how much capital a given position will require, and how that compares to pieces in our portfolio, as well as the portfolio as a whole. Another reason that BPR is so important, is because tastytrade often conducts studies and backtests in order to better understand how a wide variety of historical positions have behaved and performed.
Buying power reduction comes into play because it relates to capital usage. And while many studies at tastytrade focus on risk vs. reward, a good amount also examine profit vs. capital usage. In the latter case, that means we are seeking to better understand the maximization of profit relative to capital usage. Tying it all together, capital usage is often represented in “buying power reduction” terms in these analyses.
So now we know what BPR is, and why it is referenced so often at tastytrade
Dovetailing perfectly with this topic is a new episode of Market Measures, which provides new insights on buying power reduction (BPR).
The main focus of the episode is to help traders better understand what trading levers have the most impact on BPR. And while the mechanics of calculating BPR manually are presented on the show, the hosts assert that this isn't the best path toward BPR enlightenment.
One reason is because the BPR calculation is somewhat complicated and will vary according to which product is being traded (e.g. stocks, options, futures, etc…), the type of trade being deployed (directional, naked option, defined risk, undefined risk, etc…), and even the type of investment account in question (IRA, margin account, portfolio margin account, etc…). If that all wasn’t enough, these calculations also vary depending on the approach used by the financial institution where the account is housed.
Instead of diving into this minutia, a series of charts are presented on Market Measures to help illustrate how BPR behaves when different elements of a given trade are "shocked." Visualizing these levers at a high level should help traders more easily identify how BPR is affected by some of the more important trade criteria.
For example, the first chart (as shown below) makes it quite clear that as the price of the underlying in question increases, so too does BPR:
As shown above, the correlation between the price of the underlying and BPR is extremely strong, 0.98. That means as the underlying price goes higher, so too does the cost of deploying and maintaining the position.
Moving on, another factor that the Market Measures team examined was “initial credit received,” or the amount taken in when deploying an individual position or spread that produces a credit to the investment account. In this case, the correlation between BPR and “initial credit received” was almost nonexistent, at 0.17. That level of correlation indicates that the two don’t move together, or apart, on a consistent basis.
The last factor examined on the show is delta, or the degree to which an option is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). In this case, the study illustrated clearly that as the delta of the option increases, so too did buying power reduction. Once again, this makes sense because the degree to which an option is ITM, ATM, or OTM is once again often a component of the BPR calculation.
We recommend taking the time to review the complete episode of Market Measures focusing on buying power and buying power reduction (BPR) when your schedule allows. If you want to dig into more details on buying power reduction, we also recommend reviewing this previous blog post - What is Buying Power?
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.