Carley Garner is an experienced futures and options broker with DeCarley Trading, a division of Zaner Group, in Las Vegas, Nevada.

Carley Garner.

Coping with Margin Calls

Unlike equity accounts, in which margin is granted only to a few, all futures accounts are margin accounts. Further, this margin is granted without any cost or strings attached. Accordingly, it is up to traders themselves to keep their risk and leverage at reasonable levels.  Unfortunately, not all market participants are capable of doing so.

Thanks to movies and other media outlets, many beginning traders have become overly frightened by the idea of a margin call. Truth be told, if you trade responsibly, you shouldn’t receive many, but it can—and eventually will—happen. When it does, there’s no need to panic; most margin calls can be alleviated via position adjustment instead of adding funds to the account or outright liquidating trades. A good brokerage will be able to help traders to do just that.  However, for those trading with an inexperienced broker, or brokerage, your positions might be liquidated at the first sign of trouble without any opportunity to alleviate the margin shortage. This can be a painfully expensive lesson to learn. In short, being aware of the mechanics of margin and choosing a brokerage with a flexible and accommodating policy when it comes to alleviating margin calls might be the most important steps a trader takes to improve the overall outcome of trading ventures.

What Is Margin?

The margin is simply a specified amount of funds stipulated by the exchange and required to be held in a brokerage account to enter and keep open positions in a futures market. In its simplest form, it is a good-faith deposit or financial collateral used to cover credit risk. By demanding margin required to trade in any given contract, the exchange mitigates the possibility of traders defaulting on their trading; in other words, margins reduce the odds of traders losing more money than they have on deposit, which causes them to fail to meet their obligations to those on the other side of the trade.  This is how futures exchanges guarantee all transactions.  While that seems like a given, it isn’t.  Forex traders run the risk of making a winning trade but not being able to withdraw their profits from the account if the other side of the trade wasn’t able to cover the trading loss.

Although the futures exchange sets margin requirements, brokerage firms have the authority to increase margin rates. That said, brokerage firms are forbidden from decreasing margin or allowing undercapitalized traders to hold positions in the long term.  We will soon discuss that this rule does not apply to day traders.

Additionally, keep in mind that margin requirements are dynamic. The exchange and brokerage firm can change them at any time and without notice.

Initial Margin

You can use the terms initial margin and margin synonymously. Specifically, initial margin is the amount of capital the exchange expects a trader has on deposit in a corresponding trading account to hold a given futures contract, or short option position, beyond the close of trade of the session in which the order was executed. Simply put, if the initial margin on a T-note futures contract is $1,400, a trader should have at least this much in his trading account to buy or sell, and hold, a single contract.

Initial margin should be looked at as the minimum funding for holding a particular position beyond the close of any trading session. However, the appropriate funding is much higher in my opinion.  In summary, the initial margin is the bare minimum a trader should have in a trading account but those wishing to trade profitably, as opposed to thrill seek, should consider holding considerably more than the initial margin requirement.

Maintenance Margin

Maintenance margin, on the other hand, is the minimum account balance that must be maintained at the close of trade to avoid a margin call. The maintenance margin is typically 90% of the initial margin. When the account equity dips below the maintenance margin measured on the close of trade on any particular day, a margin call is triggered, and the trader is required to bring the account equity above the initial margin requirement by either liquidating positions, adding funds, or mitigating the margin through position adjustment. Bringing the equity above the maintenance margin level is no longer enough; once a margin call is triggered the account must be above the initial margin requirement at the close of the trading session to alleviate the margin call.

It is important to note that margin calls are not relieved until the account is within the required initial margin at the close. Beginning traders often assume that if they get the account under control on the morning of the margin call, what happens the rest of the day is irrelevant.  However, this is not the case.  If a trader liquidates or adjusts positions or wires funds to meet the margin call in the morning but the positions in the account move adversely to the point in which the account is under margined at the close of trade, the margin call will age to the next trading session. In short, margin calls can only be met by ensuring the account is within the requirements at the close of the trading session.

Day Trading Margin Versus Overnight Margin

A big misconception looms concerning how margin is levied by the exchange. Most people assume that traders must have the proper exchange-required margin to enter a position. This isn’t necessarily the case; instead, the brokerage firm, or your individual broker, determines whether you have the adequate margin to initiate a trade. Exchange-stipulated initial margin requirements don’t come into play until the end of the trading session. At this time, the exchange margins any open positions accordingly. Many traders are surprised to discover that the exchanges have little say on the margin charged for day trading activity, which is any buying or selling of futures and options that takes place during a trading session prior to the close of trade. To further specify, most futures and options markets trade 23 hours per day; a day trade is considered any position entered and offset within that time frame. Thus, it is possible for a trader to purchase an E-mini S&P 500 futures on the open of trade at 5:00 p.m. Central on a Tuesday, and offset it just before 4:00 p.m. Central on Wednesday without being subjected to the exchanges initial margin requirement.  Although the position was held overnight, it is considered a day trade because the entry and exit occurred in a single trading session.  With that said, not all brokerages grant day trading margin rates for orders placed in the overnight session, so the ability to hold a 23-hour trade based on highly discounted day trading margin rates will depend on the brokerage being used.

Depending on a trader’s established relationship with a brokerage firm—or, more important, an individual broker—the margin charged on any intraday positions is generally anywhere from 10% to 50% of the exchange’s stipulated overnight rate. Naturally, only clients who are believed to be responsible enough to have access to excessively low margin requirements are granted the privilege because irresponsible traders are a credit risk to the brokerage. This is similar to the threats posed to credit card companies by consumers with low credit scores. With that said, some platforms can now automatically liquidate the account if it is in danger of going negative or losing more than what is currently deposited.

If auto liquidation (the process of offsetting positions once a particular loss threshold is reached) is a capability of the platform, more lenient margin policies might be offered to day traders. After all, similar to the way a trader analyzes the market in terms of risk and reward, a brokerage firm assesses clients on a risk/reward basis and proceeds accordingly. Brokerage revenue is commission based; they want you to trade, but not if it isn’t worth the potential consequences of losses exceeding available trading capital.

Therefore, traders with little money in an account can trade with a margin well below the exchange’s stated margin level without ever receiving a margin call, assuming that they always exit their positions before the close. For instance, a broker might permit a trader with an account balance of $2,500 to day-trade one E-mini S&P futures contract even though the overnight margin requirement is upward of $4,500. In extreme cases, brokerage firms have been known to extend discounted margins to traders to the tune of 5% to 10% of the overnight rate. Thus, assuming an exchange stipulated margin of $5,000, a trader might buy or sell the futures with as little as $500—or maybe less. Keep in mind that although it is not a good idea, aggressive traders have been known to abuse leverage because they have the freedom to do so.

Again, once a trader holds a position beyond the closing time of the day session, overnight margin rates are imposed and, if appropriate, margin calls are issued.

What Are Margin Calls?

The term margin call seems to infer that a trader is contacted by phone about a margin deficiency, but margin calls are typically communicated by email, thanks to modern technology. Brokerage firms provide clients with daily activity statements in which a margin call is noted, if applicable. A separate margin call notice might also be emailed to stipulate the amount of the margin deficiency and a countdown of the days.

An official margin call can only be triggered based on the value of the account at the close of trade relative to the exchange’s maintenance margin level.  If the account balance is below the maintenance margin at the close of any particular trading session, a margin call is triggered. Please note, a margin deficit during the trading day that corrects itself by the close of trade will not trigger a margin call. Nevertheless, a trader should take note that the risk exposure is excessive and action should probably be taken to bring the account to a healthier level of risk and margin excess.

How to Handle a Margin Call

Beginning traders are prone to panic when a margin call is received; however, this is an unnecessary emotion that can cause poor trading decisions. Margin calls can be eliminated in one way or a combination of three ways:

  • Partial or total account liquidation. In many cases, traders who have received a margin call notice are holding several positions. They might be spread across a handful of markets or all in the same contract.

Nonetheless, a margin call doesn’t require that all the positions be offset; the trader must liquidate enough of them to bring the account into good standing.

With partial liquidations, it is important to monitor the positions throughout the day and pay special attention to the closing prices of the contracts in your account. This is because the exchange levies margin requirements based on your positions at the close of the day session in conjunction with the closing prices of all the positions in your account. If values of the remaining positions change from the time the original margin deficit was calculated, the time the partial liquidation took place, and the close of trade, it is possible that the actions taken were not enough to eliminate the margin call.

For instance, consider a trader who is long two E-mini NASDAQ futures in which the initial margin requirement is $4,300 per contract and an account equity balance is $5,000 at the time one of the two contracts was offset. All else being equal, the trader faces an initial margin requirement of $4,300 and has approximately $700 in excess of the required funds. However, if the market drops sharply from the time the first contract was liquidated into the close, the margin call might remain an issue. In this example, this would occur if the E-mini NASDAQ drops approximately 35 points (35 x $20 = $700) from the price the position was reduced to one contract from two because the drop in the NASDAQ would cause the account balance to drop below $4,300.

  • Margin adjustment through trade and risk alteration. Although the exchange-required margins for any given futures contract are relatively fixed, it is possible to adjust the margin of your overall portfolio of positions using options or even futures. For example, a trader who is long a futures contract can purchase a put option in the same market as a method to reduce the risk—and, therefore, reduce the margin requirement—on the futures contract. The same trader can also look to sell a call option for a similar but less effective impact on margin. If you are unfamiliar with options or these types of margin reduction strategies, you might be interested in reading my book Higher Probability Commodity Trading. Unfortunately, the scope of this book does not permit paying proper attention to these somewhat complicated strategies. Nonetheless, you need to realize that there are ways to alleviate margin issues, aside from throwing in the towel and liquidating the account or depositing additional funds. If the opportunity arises to utilize such strategies and your broker, or brokerage, is unable to help you, then it is time to look for another broker.

Similarly, futures traders might look to reduce their risk and, more important, margin requirement by taking the opposite position in a highly correlated contract. For instance, a trader long March corn can sell a July corn contract to mitigate margin and hopefully alleviate a margin call. This is effective because the July contract tends to move in the same direction as March. However, after such an adjustment is made, a trader faces tough decisions on how to move out of the spread. At some point, completely exiting the trade or lifting one leg at a time will be necessary. This type of strategy can be compared to putting a Band-Aid on a wound. It conceals the injury but doesn’t necessarily heal it. Moreover, the Band-Aid eventually needs to be removed—and this could be painful.

  • Wired funds. This is the most straightforward method of bringing an account within the stipulated margin requirement. Still, it is not without its complications due to the timing in which the margin is measured and levied. For example, the exchange charges margin on any positions being held at the close of trade, but margin calls are expedited late in the evening or early in the morning on the subsequent day of the issued account statement in which the margin call was triggered. The trader then has the entire trading session to act before margin is calculated again.

Market conditions frequently are drastically different from the time the initial margin deficit is calculated to the time the margin call is received—even more so by the close of trade the following day, at which point the account is reassessed. Therefore, it is possible for traders to wire funds to meet the stated margin call, only to find out that, due to adverse price changes in the remaining positions, the wired amount was not sufficient to meet the call. For this reason, it is a good idea to wire more than the stated margin deficit. If the margin call is for $2,000, it is a good idea to wire at least $3,000 and preferably well over $4,000 to reduce the risk of chronic margin trouble.

 

The Margin Call Countdown

Similar to the manner in which margin is imposed, margin calls are measured in terms of days. As we have mentioned, measurement of whether a margin call has been met takes place at the close of day session trade. Any accounts that have failed to meet the initial margin requirement go into the next day with an aging margin call.

The amount of time a firm gives for eliminating the margin call varies but is most often within one to three days. Yet, it is always preferable to take care of margin deficits immediately. If you find yourself in the midst of a margin call, it might be a good idea to follow a timeline, as outlined next; carrying a margin call too long or putting the account in danger of going negative could result in forced liquidation by the margin department. Simply put, if the margin department of a brokerage firm must step in to bring an account in line with required margin, it pays no attention to the prices or circumstances of liquidation. Its goal is to get the account under control in the quickest manner possible. As a trader, you never want to put your account in a situation in which third parties have a say in when and where you exit a trade. Additionally, most brokerages charge clients fees for liquidating over-leveraged trading accounts.  For instance, it is not uncommon for a brokerage to charge $50 per contract if a client lets losses run to dangerously low account balances or aging margin calls.  I’ve witnessed this happen to over-leveraged and traders with hundreds of contracts open.  You can do the math; it adds up quickly.

Note that many deep discount brokerage firms are much stricter when it comes to margin calls. Due to their ultra low commissions, they can’t afford to accept the risk of account debits as much as a balanced firm might. As a result, they might practice tight controls that could have a negative impact on overall trading results. Once again, sometimes saving money on transaction costs is actually more expensive when looking at the big picture.

Day One

A first-day margin call, issued the trading session following the margin deficit as measured on the close of trade, is a friendly warning that you have gotten in a little over your head and should reevaluate your positions. Unless the account is in danger of losing more than what is on deposit, known as going negative (you might also hear this referred to as going debit), a brokerage firm generally allows you to treat the first day as a freebie. In other words, even in the absence of any action taken by the trader, a good brokerage will avoid liquidation of the positions.

Although action might not be immediately required, during the course of the first-day margin call, a trader should determine a plan of action that includes either wiring money, liquidating some or all the positions or, preferably, adjusting current positions to meet the pending margin call. With that said, if the trader intends to adjust the margin by using hedges with futures and options, he should begin the adjustment process on day one of the margin call.

Some brokerage firms charge margin call fees to accounts that allow the margin deficiency to go beyond the close of trade on the first day of the margin call. Fees typically range from $25 to $50 per day, starting on day two. In addition, some firms put the account on liquidation-only status.

I highly recommend that traders attempt to alleviate a margin call on the first day.  It is human nature to put our heads in the sand and see what the next day brings, but more often than not the situation gets worse as the margin call ages.  It is better to nip things in the bud by reducing risk and margin as soon as possible.

Day Two

Hopefully, traders take care of the problem on the first day; if not, on the second day of a margin call, traders are expected to take some action to alleviate the margin call. Additionally, adding positions to the account is considered irresponsible, so traders should refrain from trading unless the broker handling the account has granted consent. Excessive abuse of trading privileges can lead to tighter controls on the trading account, thus creating an undesirable situation for both trader and broker. Clearly, brokers and brokerage firms prefer that you trade more, not less, but they are also second-party risk bearers to their client’s trading accounts. Not only do brokerages answer to the exchange and pay fees in relation to client margin deficits, but they also are responsible for seeing that any debit (negative) account balances are covered. This often entails withholding broker commissions until the client refunds the account to bring it to a positive balance, or at least zero the account out.

If a trader fails to eliminate the margin deficit but has made an effort through position adjustments and/or partial liquidation, the brokerage firm generally sees it as cooperation and might grant the trader some freedom going into the third day of the margin call. Nonetheless, it is recommended that traders take care of their margin responsibilities within the first day or two of the margin call.

Day Three

If at all possible, a trader should avoid taking a margin call into the third day. However, it is understandable that, in certain circumstances, it can happen. In this situation, the trader used the first and second day wisely and reduced the margin deficit. Doing so makes it much easier to assess the actions necessary to get the margin under control. Therefore, on the third day of a margin call, traders should be seriously focused on eliminating the margin deficit, regardless of the consequences. Most brokerage firms begin to take action on an account when a margin call is carried into the third day. This means that they have the authority to liquidate the account as they see fit to bring the account within the margin requirement. Trust me, this is not something that you want to experience. To reiterate, margin clerks aren’t traders. Their sole purpose is to get the account compliant, which means they are not necessarily concerned with getting you the best fill price. Additionally, they tend to be heavy-handed, in that they sometimes liquidate above and beyond what is necessary to compensate for possible market movements in other positions. Even worse, they often charge traders an arm and a leg for the hassle of being forced to step in and regain risk control.

Accepting Margin Calls

I thoroughly believe that psychology plays the largest part in determining whether a trader is successful, and margin calls are an important part of the equation. It is imperative that traders recognize that margin calls can, and do, happen; thus, traders should be properly prepared to cope with them. Margin call management for clients is an area in which a good broker will earn his money.

Traders who understand the process and have reviewed contingency plans for margin issues stand a much better chance of defeating the overwhelming sense of panic that occurs when time and capital limits are applied to a position. Also, just as consumers are better off living within their means, traders should make every attempt to speculate within the confines of the capital available. Too often, beginning traders assume that more leverage will result in quicker profits; in reality, this couldn’t be further from the truth.  In reality, it is a good idea to get into the habit of utilizing 50% or less of the available trading margin. I’ve noticed that the higher the margin excess in a trading account, the higher the odds of long-term trading success.  Some of the better traders I’ve seen use a mere 20% to 30% of their trading account toward margin at any given time. The remaining capital works as a rainy day fund enabling traders to withstand temporary shocks in market volatility.  Unfortunately, the over-leveraged and undercapitalized traders have as strong tendency to run out of money at the worst possible time. Yet, those utilizing a small percentage of their trading capital are generally in a position to recover from large drawdowns rather than being forced to shut the game console down and walk away. This is what separates the winners from the losers.

*THERE IS A SUBSTANTIAL RISK OF LOSS IN TRADING FUTURES AND OPTIONS.

*This is an excerpt from A Trader’s First Book on Commodities written by Carley Garner.  Garner is an experienced commodity broker at www.DeCarleyTrading.com, the author of Higher Probability Commodity Trading, and a frequent contributor to Jim Cramer’s Mad Money.

 

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