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This chapter is from the book

Margin and leverage

One of the big attractions—and what makes futures exciting—is leverage. Leverage is the ability to buy or sell $100,000 of a commodity with only a $5,000 security deposit so that small price changes can result in huge profits or losses. Leverage gives you the ability to either make a killing or get killed. You need to understand how this important concept works before you trade, and a thorough understanding of the powers and pitfalls of leverage is imperative to sound money management principals, which we'll discuss later in the book.

Each contract bought or sold on a futures Exchange must be backed by a good-faith deposit called margin. This is not like buying on margin in the stock market. When a stock market investor buys on margin, he is, in effect, borrowing half of the purchase price of the stock from his broker. (Stock exchange rules prohibit borrowing more than 50%.) The investor is charged interest on the balance. This provides a degree of leverage, but nothing like commodities.

To see how powerful leverage can be, let's compare a futures purchase with a stock purchase for cash. If a stock investor buys 200 shares of a stock trading at $10, his purchase cost is $2,000. If the stock moves up by 10% to $11 per share, the investor has made $200 on his $2,000 investment, or 10%. Margin in commodity trading is like a good-faith deposit. It is a small percentage, generally in the neighborhood of 2 to 10%, of the value of the underlying commodity represented by the contract. Margin deposits are set by the Exchange, and they can change with price movements and market volatility. Because you are trading for future delivery and not borrowing anything, no interest is charged on the balance. Margin is not a partial payment or a down payment, and it's not even considered a cost. If you make money on the trade, upon liquidation, your total margin deposit is returned, along with your profits. Commissions are deducted, and they are a cost. Margin is money deposited in your brokerage account that serves to guarantee the performance of your side of the contract. Margin is a form of "earnest money" deposited by both the longs and the shorts, and it serves to ensure the integrity of every futures transaction. In effect, margin ensures that you are paid when you win, and that whoever is on the other side of your transaction is paid if you don't.

When you enter a position, you have deposited (or will deposit) the margin money in your account, but your brokerage house is required to post the margin with a central Exchange arm called the clearinghouse. The clearinghouse is a non-profit entity that, in effect, manages the daily process of debiting the accounts of the losers and redistributing the money to the accounts of the winners.

Now back to the leverage example. The margin requirement for a 5,000-ounce silver contract has been running $2,000 on average in recent years. At $6 per ounce, a contract is worth $30,000 ($6 per ounce times 5,000 ounces). If the price of silver rises by 10% to $6.60, the same contract is worth $33,000. However, suppose the same investor puts up his $2,000 and instead buys a silver contract. If the price of silver rises by 10%, or 60¢, he makes $3,000 on his contract. This is 150% on margin, not 10%. It's powerful leverage, but also a double-edged sword. If prices fall by 10%, the investor's $2,000 is now worth a negative $1,000. When you trade futures, you are responsible for the total value of a move of any position you hold. In most cases, if a market moves against you, you have time to liquidate before the account shows a deficit; however, this is not always the case. If you don't use adequate risk-control measures, or if a market moves very quickly against you, your account could go into a deficit situation, and you are obligated by contract to pay the difference.

There are two types of margin: initial margin and maintenance margin.

Initial margin is the amount that must be in the account before you place a trade. If you do not have enough initial margin in your account, you incur a margin call. Most brokerage firms require the initial margin to be in the account before they allow a trade to be placed. Some might issue credit for good customers, but they generally require that the margin call be met within one to three business days. Any firm has the right to require same-day deposit by bank wire transfer at any time and might request this during volatile markets. Maintenance margin is the amount that must be maintained in your account as long as the position is active. If the equity balance in your account should fall below the maintenance margin level, because of adverse market movements, you incur a margin call as well. After the margin call is issued, you are required to meet the call or liquidate the position. If you fail to meet a margin call in a timely manner, the broker has the right (and will use it) to liquidate the position for you automatically. This is done to protect the broker from additional adverse movements in the market, because he is responsible for meeting your margin call, even if you're a deadbeat and don't.

If you fail to meet a margin call, and the position is ultimately liquidated at a loss that leaves a deficit in the account, the broker is immediately responsible for the deficit, but you are legally responsible. In other words, initial margin might not be the extent of your liability. You are responsible for all losses resulting from your trading activities. If the market moves against you five, six, or seven days and you do not get out, if the market moves limit against you and eats up your margin, you are still responsible for any and all losses. Later in the book you'll learn ways to manage the risk, but at this point be aware that whenever you trade futures, your risk is not limited to the initial margin or your account balance. It can go further than that. (Options work differently; they will be discussed later in the book.)

Here's a typical example. Assume silver is trading at $6 per ounce, and the initial margin requirement is $2,000. A silver contract has a size of 5,000 ounces, so at $6 per ounce, the total value of the contract is $30,000. However, all that is required to purchase or sell a contract is $2,000 (in this example, about 6%). A rule of thumb for maintenance margin is that it will be at the 75% level of initial. If the initial is $2,000, for example, maintenance might be $1,500. If you have an account value of $20,000 with no other positions on, you could buy 10 contracts without a margin call; however, this is not recommended because you would be overtrading, or too highly leveraged, and a relatively minor price movement would move you into margin call territory.

For illustrative purposes only, let's assume your account balance is at $20,000 and that you buy 10 silver contracts. Your maintenance level is at $15,000. If the market starts to move your way immediately, you're OK. Because a silver contract is for 5,000 ounces, a 1¢ move results in a profit or loss per contract of $50. In this example, the 10 contracts give you a profit or loss of $500 per penny move. Suppose you buy the 10 contracts at $6, and the market closes that same day at $6.05. Your account balance is $22,500 on the close of business that day. You have an unrealized profit of $2,500. The profit is unrealized because the position is still open. The increase in equity value of $2,500 is the result of the 5¢ move in your favor (5¢ times $50 per contract times 10 contracts). Suppose the next day, the price falls 10¢ to close at $5.95. Your account value decreases by $5,000 to $17,500. You would not have a margin call, because your value still would be above the maintenance level. If on the next day prices rose 5¢ to $6, your equity value would move back to $20,000.

Basically, the futures is the process of generating a credit or debit daily against your initial position until you close it out. If you make money on any particular day, the unrealized credit balance is credited immediately to your account and debited from the people on the other side of the transaction. (You will never know who they are because it's completely anonymous, but they are out there.) If the market closes against your position on any particular day, the loss would be immediately debited from your account.

Now, let's get back to the example. On the fourth day, the market drops 25¢ to close at $5.75. Your account is debited $12,500 (25¢ times $50 per contract times 10 contracts). Your equity balance is now down to $7,500, which is below the maintenance margin level, so it's margin call time. You now get a communication from your broker, who informs you about your $12,500 margin call. You see, after your equity level falls below the maintenance margin level, you are required to bring your balance up to the initial margin level. You now have two choices: You can either liquidate the position in whole or in part, enough to move your equity back above the initial margin level, or you can meet the call. In this case, you could sell out seven contracts, realize your loss on those seven, hold onto the three, get your initial margin down to $6,000, and hope the market recovers. If you feel strongly about the position, you could opt to meet the call. Let's say you send in a check, or if required, wire transfer the $12,500 to your account. Your account balance now shows $20,000, so you are "off call." You have deposited $32,500 into your account at this point, but if you close out the position at the current price of $5.75, you have a balance remaining of $20,000 minus any transaction costs. If your thinking is correct, and the silver market recovers to $6, your account balance would grow back to $32,500. You now have the right to request that the $12,500 (the amount over the initial margin) be sent back to you. If the market falls again, however, you could certainly be issued another margin call.

It is important to leave a cash cushion in the account so that you have the ability to ride out normal market fluctuations without receiving a margin call. My general rule of thumb is to never margin yourself higher than 50%. In other words, if your account value is $25,000, I would not put on positions that, at most, would require more than $12,500 in initial margin.

Each market has its own margin requirement. This requirement is based on the volatility of the particular market and also the volatility of the markets as a whole. Greater volatility equals greater risk and higher requirements. The S&P 500 index and the NASDAQ are two of the more volatile contracts, and it is not uncommon to have a daily range of $5,000 per contract or more in value. The margin requirement for the S&P can be in a normal period from $7,000 per contract on up. I have seen the NASDAQ in the high-priced days with $20,000 range days and $30,000 margin for a single contract. On the other hand, corn is traditionally less volatile, and in a normal market, it might have a price range of $250 per contract. The initial margin might be $400 in a quiet market, but it could move up to $1,000 in a volatile environment for corn prices.

Here's another important point on margins: Although the Exchange sets a minimum margin requirement, individual brokerage houses have the right to charge higher than "Exchange minimum." This protects the brokerage house from over-traders who tend to plunge (trade in excess of prudent speculation, even in excess of their ability to pay), which would require the broker to make good on his commitment to the clearinghouse.

The entire point of this margining system is that all positions are "marked to the market" by the clearinghouse daily and revalued to the current market price. As such, profits and losses are paid daily.

One last point about margins: The Exchange allows initial margins to be posted either in cash or (in the United States) U.S. government obligations of less than 10 years to maturity. If an investor wishes to post T-Bills for margin, he can do so; most commodity brokers will pass the interest back to the customer. So, in effect, the initial margin earns interest.

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