“Woe to the land whose king is a child and whose leaders are already drunk in the morning. Happy the land whose king is a nobleman, and whose leaders work hard before they feast and drink, and then only to strengthen themselves for the tasks ahead”. (Eccl 10: 16-17)


"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat


Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput


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Saturday, November 5, 2011

Margin Call Process

Many of those who read this site are equity traders and do not live in this exotic world of commodity futures trading as I do and others who read this site. Also, some are relatively new to the world of trading in general and perhaps are reeling at all this talk of  "initial margin requirements", "maintenance margin levels", "margin calls", etc. I therefore thought it might not be a bad idea to provide a very brief explanation of what these things are so they can understand what all the fuss was about this past 24 hours as we sought to understand what was taking place as a result of the original advisory notice put out by the CME Group which was then fortunately clarified later on.

Initial margin requirement is the sum of money necessary to either buy or sell  a single commodity futures contract. For the sake of our illustration, let's say that the DME (Dan's Mercantile Exchange) set the INITIAL margin requirement for a single contract of corn at $1,000. If you want to BUY or SELL one corn futures contract, you need to have at least $1,000 in your trading account or nothing doing amigo.

Now let's say that the DME sets the MAINTENANCE MARGIN level for that corn contract at $750. This is the level at or under which you are going to receive a margin call if your account balance falls to this level or lower. The margin clerk will then notify you that if you wish to continue holding this position open, you are going to have to send enough additional money to bring your account balance back up to the INITIAL MARGIN level; in our case back to $1,000.

At that point, you have one of two options - you can bank wire the sum of $250 or more or you will be forced by your broker to liquidate the corn position by either selling it or buying it back if you were short.

Now let's see how this might work in actual practice. You start out with an account of say, $20,000. In keeping with the DME exchange (I have always wanted to have my own commodity exchange!) you could conceivably BUY or SELL a total of 20 corn contracts as the initial margin is $1,000 for a single contract. That of course would not be wise but believe it or not some traders actually are foolish enough to attempt this.

Let's say you are a bit more prudent and take out a LONG position by buying 15 corn contracts (notice I said, "bit more prudent" - this is still very foolish as I will explain later). That means you have $15,000 in a $20,000 account tied up in initial margin requirements.

You bought your corn at $6.50 a bushel and are feeling good about your prospects. Unfortunately, no sooner than you get your fill price then the RISK OFF trades start and your corn drops $0.10 down to $6.40. Each 1 cent move in corn is $50 so for each contract of corn you own, you now have a paper loss of $500 ( 10 cents * $50). Since you have a total of 15 corn contracts, the paper loss is 15 * $500 or $7,500. That did not take long did it? Welcome to the leveraged world of commodity trading.

Your account balance is now $12,500 ($20,000 initial - paper loss of $7,500). Things begin getting dicey at this point. MAINTENANCE LEVEL at the DME for corn is $750 for a single contract. You have 15 corn contracts. So you need to keep your account balance above $11,250 ($750 * 15 contracts).
You have a cushion of $1250 left ($12,500 - $11,250). If corn drops another 2 cents, the margin clerk pays you a visit. WHY? Because your total account balance has now dropped $1500 further (2 cents * $50 * 15 contracts). It is now at $11,000 when the MAINTENANCE LEVEL is $11,250.

At this point you will receive a "CALL for ADDITIONAL MARGIN" (margin call) to bring the total sum in your account back to the INITIAL MARGIN requirement to hold 15 corn contracts, which as you recall was $15,000.

You will either have to bank wire the money to your account that same day or you will be required to reduce the number of corn contracts you have bought to a level low enough that you are above the maintenance margin levels. You might sell 5 contracts at a loss leaving you a total of 10 corn contracts. Maintenance margin levels for TEN corn contracts would be $7500 (10 contracts * $750). Since your account balance is at $11,000 you would then be okay.

This example is the reason that futures traders should NEVER trade in a size large enough to threaten the integrity of their own trading account. I have told many potential traders that in my opinion, a trader who starts off with $20,000 in trading account should trade NO MORE than TWO corn contracts. Even at that you would want to cut any losses quickly and limit losses to no more than 5% of your total account balance. That means $1,000 on a single trade.

This is also the reason why exhange changes in margins and maintenance margin levels can cause such a huge impact on individual commodity markets when they occur. Traders who are leveraged up to the gills as in the example of our overtrading trader above (15 corn contracts in a $20,000 trading account) are always the first to get hit by these events. Seasoned traders use margin sparingly realzing how dangerous leverage can be when it is working against you.

8 comments:

  1. Nice description, Dan. What you describe is a normal market. Now when the Evil Empire conducts their takedown of the Gold market, you have a higher level of margin reduction which can wipe out a trader in a heartbeat.

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  2. Thanks for your detailed explanation. It helped newbies like me greatly. Now that the CME makes the initial margin and the maintenance margin the same, does it mean that even when a person went under on the maintenance margin and receive a margin call, now they have to wire less cash as before to get back to initial margin, meaning it becomes easier now to meet their margin call. Wouldn't this cause traders to be even more aggressive in terms of taking more risk? Volatility is going to spike up, wouldn't it? Please help me to understand.

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  3. Thanks Dan for that easy to understand explanation

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  4. Here's what I understand: CME can steal your money with a mouse click. But if they want to steal real gold and silver in a gun safe bolted two feet into rebar, CME will have to be good enough to get past two German Shepards and a 12 ga. If they're really that good, they can have it. That's what I understand.

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  5. Wow!
    if I understood it right it is more margin calls when market opens, more liquidity pouring in for troubled accounts that can afford holding position and more accounts wiped out for those who cannot, is it a financial nuke higher in magnitude than 2008? is it the second domino after the first ( MF global ), the next few days and weeks are going to tell the story.

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  6. Does the DME take monopoly money? I think it will have far more purchasing power than the FRN in the near future!

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  7. Hey Dan found this on the internet


    HERE'S THE LATEST ON THE MAN FINANCIAL FAILURE

    It seems to be good news...

    This story is taking more form; my sources say the CME finished their audit and most funds have been accounted for. Some 15,500 retail accounts and 1.5 billion in assets were transferred out Friday night to other firms.

    The claim will be an error took place at a low executive level; 1 Billion was transferred out of segregated (protected customers funds) into Man house accounts. The suspicion is this was used for a Man Financial position...short 3bn in Italian Bonds!

    Jon Corzine claimed to be unaware of the position. Once he found this out, at approximately 3am last Monday, he personally got on phone and bought back the 3bn worth of Italian bonds they were short.

    He then files for chapter 11, then stays on to work out of the trade until it settles Wednesday and Thursday, resigns Friday.

    The problem was a huge bet using 30 to 1 leverage. I guess the bet was to offset his comment a few years back that MF Global was "too small to care about". The bet size changed all that!

    The hope is this should be happy ending... unless regulators and lawyers tie up the funds in litigation and compliance.


    This was a post on the internet by Larry Williams so it must be for real !!!

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  8. Thanks Dan. That was very helpful.

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