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.

IMPORTANT UPDATE - CME CLARIFIES CHANGES IN MARGIN REQUIREMENTS

I would like to publicly express my appreciation for my pal JB Slear, a dedicated commodity futures broker who operates Fort Wealth Trading for putting in yeoman's hours, over a weekend I might add, to help track down what is occuring with this CME margin changes.

Here is the official clarification from the CME Group where they state that instead of raising maintenance margin levels to initial margin levels, they are doing the opposite, and instead LOWERING initial margin requirements to maintenance levels.

Also, thanks to "KId Dynamite" for posting his view earlier that this is what they were doing.

DATE: Saturday, November, 5, 2011

NOTICE # : 11-400

SUBJECT: CME Group Clarifies Maintenance Margin Ratios; Exchange to Reduce Initial

Margin Ratio to 1.00

                                   

FOR THE FULL TEXT OF THIS ADVISORY :

http://www.cmegroup.com/tools-information/lookups/advisories/clearing/files/Chadv11-400.pdf

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CME Group Clarifies Maintenance Margin Ratios; Exchange to Reduce Initial Margin

Ratio to 1.00

CME Group today is clarifying its notice to clearing firms regarding margins.  In light of the issues customers transferring out of MF Global are facing, while still maintaining appropriate risk management protections for the market, CME Clearing is setting the "initial" margin upcharge at zero. This upcharge is normally applied to customer accounts when they are receiving a margin call.

The intent and effect of these changes is to decrease the size of any margin calls resulting from

the bulk transfer of MF Global customers to new clearing members, not to increase them.

Yesterday, CME Group successfully transferred MF Global customer positions to a new clearing member with part, but not all, of their funds, as approved by the bankruptcy trustee and the court. By reducing the initial margin “ratio” to 1.00, we ensure that margin calls that are issued to these transferred MF Global customers will be limited to bringing their accounts into compliance with the lower, “maintenance” margin levels. Maintenance margins are set to provide appropriate risk management coverage. Initial margins are set to provide an additional buffer against future losses in the account.

This is a short term accommodation to maintain market integrity and provide temporary relief to customers whose accounts have been disrupted by this event.

We apologize for any confusion our initial advisory may have created.

Trader Dan on King World News Weekly Metals Wrap

Please click on the following link to listen to my regular weekly radio interview with Eric King on the KWN Weekly Metals Wrap.

http://tinyurl.com/3n3g3uh