Part II · Markets · Chapter 2E

Accounts, margin and taxes

Account types and the Section 1256 advantage

Two strategies with identical pre-tax profit and loss (P&L) can produce wildly different after-tax outcomes. The difference depends on the wrapper, on the account type and on whether the underlying instrument qualifies for Section 1256 treatment under American tax law. This is one of the genuinely free lunches available to American retail traders. Most retail strategies fail to capture it, because they default to the most familiar instrument (SPY) instead of the tax-optimal one (XSP, ES or SPX).

1 · The four account tiers

American brokerage accounts come in four primary capacity tiers. Each has different rules about what can be traded and how much leverage is available. Capacity escalates upward: you cannot trade naked short calls in a cash account, but you can do everything a cash account permits in a portfolio-margin account. Chapter 1E teaches how margin, margin calls and forced liquidation work in general. This section gives the rules of each tier, and Chapter 12G the margin charged on each options structure.

Cash account

A cash account trades with settled funds only, with no borrowing and no naked short option. Cash-secured puts, covered calls, long options and long stock are all permitted in this default retail tier.

A trade settles when the cash and the securities actually change hands. As of May 2024, when the SEC moved the standard from T+2 to T+1, equities settle T+1, one business day after the trade, and options settle T+1 as well.

The cash account is structurally safe, because you cannot lose more than you have. There is no margin extension to draw down, so there is no margin call and no forced liquidation. The price is capital inefficiency: cash-secured strategies tie up capital dollar for dollar against potential assignment. A cash-secured XSP put struck at 600 holds $600 \times \$100 = \$60{,}000$ of cash for as long as it is open.

Reg-T margin account

A Reg-T margin account follows fixed-percentage margin rules under Federal Reserve Regulation T. The initial margin on a stock purchase is 50%: you can borrow half the price. The maintenance margin is 25%: your equity must stay above a quarter of the position's value, or you get a margin call. Options buying power is generally limited.

Those two percentages fix how far a position bought on margin can fall before the call. Suppose you buy stock worth $V_0$ with initial margin $i$, so you borrow $L = (1 - i)\,V_0$. When the stock is worth $V$, your equity is $V - L$, and the maintenance rule requires $V - L \ge m\,V$. The call comes when the value falls to

With $i = 50\%$ and $m = 25\%$, that is $0.50/0.75 = 0.667$: a fall of one third. Buy $20,000 of stock with $10,000 of your own money, and the call arrives when the holding is worth $13,333, where your $3,333 of equity is exactly 25% of it.

Pattern day trader rules cover active accounts under $25,000. A day trade opens and closes the same position on the same day. An account with less than $25,000 of equity that makes four or more of them in a rolling window of five trading days is flagged and restricted. Most retail accounts with $2,000 or more of equity qualify for Reg-T margin. The permission to sell naked short options requires specific approval and demonstrated experience.

Portfolio margin account

A portfolio margin (PM) account sets margin from stress-tested theoretical losses. It requires $125,000 or more of equity, the minimum set by FINRA, the regulator of American brokers, and the broker's approval. Chapter 12G adds that brokers typically ask for $125,000 and sometimes $150,000 to $200,000.

The requirement is computed against a scenario of SPX moving 15% either way, combined with shifts in implied volatility. For diversified, well-hedged books, the requirement is dramatically lower than under Reg-T. For an iron condor on SPX with both wings 5% out of the money, Reg-T might require collateral equal to the full wing width. Portfolio margin might require only the loss that would occur in the ±15% scenario, perhaps a third of the Reg-T number.

The catch is that PM requirements expand non-linearly in stress, sometimes doubling or tripling overnight as the broker's house overlays kick in. This is a critical feature, not a bug, and the section on margin in stress returns to it.

Futures account

A futures account, or 1256 account, is separately permissioned for futures (ES, MES, ZN, CL and others) and for options on futures. ZN is a Treasury-note future and CL a crude-oil future. Futures use SPAN margin, developed by the CME and computed against a matrix of stress scenarios. It is typically 5% to 8% of notional for the major equity futures. Both gains and losses receive 1256 60/40 tax treatment, regardless of holding period.

ES at SPX 6,000 has a notional of $300,000, and its initial margin is around $15,000 to $22,000 depending on conditions, with intraday margin sometimes lower. Chapter 12G quotes roughly $13,000 to $15,000 of initial SPAN margin for one contract. At $15,000 the position is $300{,}000/15{,}000 = 20$ times the margin, and at $22,000 about 14 times. This is genuinely powerful leverage with clean tax treatment. At 20 times, a 5% fall in the index takes the whole $15,000.

2 · Section 1256: the 60/40 rule

Under Internal Revenue Code Section 1256, certain financial contracts receive a uniquely favorable tax treatment that applies regardless of holding period. A Section 1256 contract has its gains split:

1256 split: 60% long-term + 40% short-term

A long-term capital gain comes from a position held more than a year, and a short-term capital gain from one held a year or less. Short-term gains are taxed at the ordinary income rate, long-term gains at a lower rate. For a 1256 contract the split ignores the holding period, so even a same-day trade is 60% long-term. The blended rate is therefore

where $t_{\text{LT}}$ and $t_{\text{ST}}$ are your long-term and short-term rates. Subtracting it from the short-term rate gives the saving on each dollar of gain:

For an American individual taxpayer in the top federal bracket, the ordinary rate is 37%. The long-term rate is 23.8%, which includes the 3.8% Net Investment Income Tax (NIIT). The blended rate on 1256 gains is often quoted as approximately 27% to 28%, against approximately 40% to 41% on ordinary short-term gains for instruments outside the 1256 regime. That would be roughly 12 to 14 percentage points of after-tax savings on every dollar of P&L generated by 1256 instruments.

The saving on returns follows from the rates: an after-tax return is the pre-tax return times one minus the tax rate, and $W_0$ compounds over $n$ years to

For a systematic monthly put-write strategy earning 8% a year gross, the quoted 12 to 14 points make approximately 100 basis points of after-tax return a year, turned on or off by instrument choice. The like-for-like 10.2 points make about 80: at the top bracket with the surtax, 8% becomes $8\% \times (1 - 0.408) = 4.74\%$ on SPY and $8\% \times (1 - 0.306) = 5.55\%$ on XSP.

Over a decade of compounding the gap is substantial. As a rough rule, 100 basis points a year for 10 years is roughly 10% more terminal wealth, before the compounding of the saved taxes themselves, which adds another few percent. Computed with (2E.4) at the like-for-like rates, $1 grows to $1.59 on SPY and $1.72 on XSP in 10 years. The XSP account ends 8% larger, a gap of 13% of the starting capital.

What qualifies

1256-qualified instruments include:

• Cash-settled broad-based index options: SPX, XSP, NDX, RUT, VIX and NDXP.
• Regulated futures contracts: ES, MES, ZN, ZB, CL, ZC and GC, and all CME, CBOT, NYMEX and COMEX equity, rate and commodity futures.
• Options on regulated futures contracts: ES options, MES options and so on.
• Broad-based index options on Cboe, whose operative legal definition is in IRC §1256(g)(3).
• Non-equity options that meet the "broad-based" test.

1256 does not cover:

• ETF options, such as SPY, QQQ and IWM. These are equity options, not index options, even though they track indices.
• Single-name stock options.
• Narrow-based index options, such as some sector ETFs and individual industry indices.
• Stocks themselves, to which the standard short-term and long-term capital gains rules apply.

The broad-based index test for index options requires, loosely, that the underlying index include 10 or more component securities and that no single component exceed 30% of the index weight. SPX clearly qualifies, while sector ETF options such as XLE or XLF do not.

3 · SPY against XSP: the one decision that matters

This is the single highest-leverage operational choice in retail systematic options strategies, and it costs nothing to make. A retail trader running monthly cash-secured at-the-money puts on SPY or on XSP sees identical pre-tax P&L, apart from a few basis points of spread. After tax, in the top bracket, XSP keeps roughly 10 more cents of every dollar of pre-tax profit, over a multi-year horizon. Its only operational price is its slightly wider bid-ask spread, which costs perhaps 5 to 10 basis points a year and is easily outweighed by the tax saving.

Over a decade of compounding this gap is a small house. The only operational change required is opening the XSP order ticket instead of the SPY one.

4 · Wash sales

The IRS wash-sale rule disallows a loss on a security if a "substantially identical" security is bought within 30 days before or after the sale that realized the loss. For stocks and most ETFs this rule is easy to trigger accidentally. Selling SPY for a loss and buying it back two weeks later disallows the loss, deferring it into the cost basis, the tax purchase price, of the new position.

For 1256 instruments, wash-sale rules do not apply. Losses can be realized and immediately re-established without disallowance. This matters substantially for any strategy with frequent roll activity, or one that legitimately needs to harvest losses against gains for tax planning. A trader running monthly XSP credit spreads who has a losing month can close the position, realize the loss for tax purposes and immediately re-enter a similar position. The loss is fully usable against any other gains in the same year.

The wash-sale exemption for 1256 contracts is buried in the Internal Revenue Code and rarely discussed in retail education. It interacts with the mark-to-market provision of §1256, which requires you to mark all open 1256 positions to market at year-end and treat any gain or loss as recognized. The result is a clean tax accounting in which every gain and every loss flows through to the tax computation in the year it occurred, with no carryforward complexity from disallowed losses.

5 · What the tax gap compounds to

The figure compounds $100,000 for a chosen horizon at an annual P&L, taxed two ways. SPY gains are taxed as short-term gains at the ordinary rate, federal plus state. XSP and SPX gains are taxed under 1256, 60% at a long-term rate and 40% at the ordinary rate. The sliders set the federal bracket (10% to 37%, starting at 32%), the state tax (0% to 13.3%, starting at 5%), the annual P&L (5% to 100%, starting at 20%) and the horizon (1 to 30 years, starting at 10). A table gives each regime's effective rate, after-tax annual return and terminal wealth, and the bars draw the terminal wealth.

The model is simple. It takes the long-term rate that goes with the federal bracket, rounded to the bracket boundaries (0% up to the 12% bracket, 15% from 22% to 35%, 20% at 37%). It charges state tax on the whole gain in both regimes, and it leaves out the 3.8% surtax. Read its output as the size of the gap, not as your tax bill. Start at the defaults, then set the annual P&L to 8%, the put-write return used above.

federal bracket

32%

state tax

5.0%

annual P&L

20%

horizon

10y

From $100k	SPY (1099)	XSP / SPX (1256)
Effective rate	37.0%	26.8%
After-tax annual	12.60%	14.64%
Terminal wealth	$327,630	$392,068

terminal gap = $64,438

gap = 19.7%

tax-rate spread = 10.2pp

At the defaults, the ordinary rate is $32\% + 5\% = 37.0\%$. The long-term rate in the 32% bracket is 15%, so the 1256 rate is $0.6 \times 15\% + 0.4 \times 32\% + 5\% = 26.8\%$, a tax-rate spread of 10.2 points. The after-tax returns are 12.60% and 14.64% a year. After 10 years, $100,000 becomes $327,630 on SPY and $392,068 on XSP or SPX: a terminal gap of $64,438, or 19.7%. At an 8% annual P&L, the two grow to $163,511 and $176,667, a gap of 8.0%, close to the like-for-like decade computed above.

The figure shows the gap growing with the P&L and with the horizon, because the saved tax compounds. By (2E.3), the spread between the two rates is 60% of the gap between the federal rate and the long-term rate, and state tax, which falls on both, drops out of it. So the spread moves with the bracket: 7.2 points at 12%, 4.2 at 22%, 10.2 at 32%, 12 at 35% and 10.2 at 37%.

6 · Margin in stress: the real cost of portfolio margin

Reg-T margin requirements are fixed and formulaic (50% on stock, fixed formulas on options), so they do not change in stress. Your margin requirement is the same on Monday as it was on Friday, regardless of overnight news.

Portfolio margin requirements, by contrast, are stress-tested. The broker computes what your portfolio would lose if SPX moved 15% either way along with implied-volatility shocks, and requires you to post collateral against that theoretical loss. In calm conditions, PM allows far more leverage than Reg-T: diversified, hedged portfolios can run at 5 to 10 times the leverage that Reg-T would permit. In stress, PM requirements expand violently.

The canonical worked example is March 2020, the first three weeks of the COVID drawdown:

That is a fall of $2386/3338 - 1 = -28.5\%$ at the close, and nearly 32% to the intraday low, while the VIX rose almost fivefold. In the same period, four things happened at once:

• Many PM accounts saw their margin requirements double or triple in 1 to 3 days, as brokers increased their house-overlay add-ons.
• Brokers adjusted the ±15% scenario itself upward, some to ±20% or ±25%, as the realized-volatility regime shifted.
• The implied-volatility shock components of the stress test grew larger as the VIX rose.
• Volatility-targeting funds began de-grossing, cutting their positions, which fed back into the PM margin calculations as the VIX rose further.

The combination produced a wave of forced liquidations across PM accounts. Traders who had been running at "comfortable" pre-stress leverage, say 4 times, found themselves facing requirements of 8 or 10 times after the margin expansion, with no time to raise additional collateral. The broker's algorithm sells positions to bring the account back into compliance with the new margin level. That selling adds to the SPX downside, which raises the VIX further, which further expands margin requirements at other PM accounts. The feedback loop has exactly the same structure as the dealer-hedging loop of Chapter 8D, operating through margin accounting instead of options Greeks.

The strangle's scenario grid above shows the first link in that chain. Widening the scenario from ±15% to ±25% more than doubled its requirement, from $4,800 to $10,800, with no change in the position and before any volatility shock or house add-on.

The structural lesson is that cash-secured strategies cannot be force-liquidated for margin reasons, because there is no margin extension to expand. This is the operational reason cash-secured XSP put-writes are the recommended retail vehicle for harvesting the variance risk premium (VRP), even though they are capital-inefficient next to PM-leveraged versions of the VRP harvest. The capital inefficiency is the insurance premium against the path-dependent risk of margin expansion in stress (Chapter 1E). Portfolio margin is genuinely useful in calm conditions. It is genuinely dangerous in stress, and the danger comes at precisely the moments when you most want your account to survive intact.

7 · The decision tree: five products, three accounts

Cash account: XSP cash-secured puts, capital-bound but operationally the safest. Avoid SPY for any systematic strategy: the tax penalty is large and unnecessary.

Reg-T account: SPY or XSP diagonal or vertical spreads if you need defined-risk leverage, and ES futures through the 1256 route if you want clean leveraged equity exposure. The Reg-T tier is a good middle ground for traders who have outgrown cash accounts but are not ready for the margin-expansion risk of portfolio margin.

Portfolio margin account: sized XSP strangles or condors against a known stress budget, with explicit, pre-committed kill criteria for margin-expansion scenarios. Do not touch PM until you have at least 12 months of cash-account or Reg-T experience with the strategy and documented adherence to your written kill rules. The first PM account every trader opens is operated incorrectly. The second is operated more carefully, because the first one taught lessons that no amount of reading could have.

The two traditions this book draws on disagree about the condors in that line, and both positions stand. One lists XSP strangles and condors among the portfolio-margin strategies and teaches the iron condor as an intermediate structure (Chapter 12C). The other rejects systematic iron condors in a retail account, on the evidence that Chapter 1D summarizes and Chapter 10I sets out in full. Read those chapters before running one.

The choice between cash, Reg-T and PM is one of the most consequential a retail trader makes, and most retail traders make it badly. They jump to PM too early and fail to write down stress-scenario kill rules. They also do not understand that PM margin requirements are path-dependent in a way that Reg-T's are not.

8 · Check yourself