Commodities

If You Want Your Money Back Don’t Break Anything

dondawson
Don Dawson
Instructor

Isn’t it funny how when you see a headline about your money that you want to read more?  It is human nature to want to protect our hard earned capital and to make it grow as much as possible with as little risk as possible.  Something that helps make small amounts of capital grow as much as possible is leverage.  To get leverage a trader uses margin which is sometimes called a performance bond.

Margin allows a trader to post small amounts of capital to control large sums of notional contract values.  Using margin will give higher return on investment (ROI) percentages than using pure cash for the transaction.   Futures contracts are very large and would require large amounts of capital if a trader were to pay all cash for it.  If a trader were to pay all cash for the transaction this might tie up a very large portion of their portfolio in one Futures market.  If too much of a portfolio is in one market this does not allow for portfolio diversification.  The trader would have to be right on their bet about the market’s direction or they will lose capital.  If the trader were to use margin instead of paying all cash they would only be required to put up between 5 and 10 percent of the total contract value, leaving extra buying power in their portfolio to diversify into other asset classes.

When viewing Commodity Futures prices on your computer, newspaper, financial television shows etc. the quote is only for a unit price of that Commodity.  If you see Crude Oil trading at $101.34 this price is per barrel.  If you could find an oil company to sell you one barrel of Crude Oil at wholesale prices this is what it would cost you.  However, the Futures markets trade in standardized contract sizes.  For Crude Oil the standard contract is 1,000 barrels each.  Instead of using $101.34 for one barrel a trader would have to pay $101,340 to obtain 1,000 barrels.

To reduce the amount of capital required to trade these large contract sizes the Futures Exchanges allow traders to deposit smaller amounts of capital known as margin/performance bonds to control the full value of the contract.  Usually this amount is approximately 5 to 10 percent of the total contract value.  The margin may change up or down based on the risk and volatility of the individual Commodity Futures contract.  Too much risk/volatility and the Exchange will raise the margin required – if risk/volatility decreases then lower margin is required.

how margin works in the Futures marketsThe title of this article is a simple analogy of how margin works in the Futures markets.  If you and your family decided to rent a summer house on the beach (trader wishing to buy or sell a contract) you would likely be required to leave a cash deposit (margin/performance bond) with the owner (brokerage firm/clearing house) to insure that if you damaged the house in any way the cash deposit would be used to cover these damages (losses incurred for the contract bought/sold).  If the owner found damage they would deduct the repair cost from your deposit (losses that occurred while in the trade) and return only a portion of your initial cash deposit.  If the repairs were for more than your cash deposit then the owner would require more cash from you to make the repairs (losses for more than your trading account size).  After you have enjoyed your vacation and no property damage occurred (profitable trade) the owner will return your entire cash deposit and you would be able to apply it to your next vacation rental (broker returns your margin amount plus the profit from your trade into your trading account).

There are two types of margin in the Futures markets, overnight and day trade.

The overnight is set by the individual Futures exchanges that the Commodity Futures contract trades on.  Each day all of the markets are scanned with an indicator called Span by the Exchanges to check for current volatility and risk.  If the indicator detects excessive risk/volatility then the Exchange will begin raising margin requirements.  If the indicator detects lower risk/volatility it will begin to lower margin requirements.  All margins are subject to change even after a trader has an open position in the market.  The amount of margin the Exchange sets is called an Exchange Minimum and no brokerage firm can use less than this amount for overnight margin.  The monetary value of these margins can be found on Exchange websites and your brokerage firm’s website.

Day trade margin is determined by the individual brokerage firms and can be negotiable when opening a new account.  Day trade margins are only applicable to the Regular Trading Hours (RTH) and once the RTH closes the margin is increased to the overnight Exchange minimum amount for the Extended Trading Hours (ETH) session.  Day trade margins are typically less than overnight margins, but not all brokerage firms offer lower day trade margins for all markets.  Check with your broker to confirm their firm has a special day trade margin for the market you are about to trade.

The two types of margin a trader will experience while trading Futures contracts beyond the RTH session are Initial and Maintenance margins.   Margin is needed on a per contract basis.

Initial Margin is the amount needed to initially open the position on the first day.  After the close of business on the first day when a trade is held overnight the back office of your brokerage/clearing house will deduct this initial margin from your trading account and hold it until you close your position.  Margin is held as collateral to show you have capital to cover any losses you may have while you have an open Futures position.   Any cash leftover in your account after margin is removed is called buying power.

If you decide to hold the position for more than two days then the margin is reduced to maintenance margin, an amount less than the initial margin.  The difference between the initial margin you originally had taken from your account and the maintenance margin is then deposited back into your account increasing your buying power.  To maintain this open position the trader must keep their buying power positive, if the buying power goes negative then a margin call will be issued.

If your buying power goes negative then your brokerage firm will try to contact you.  They will ask you if you wish to keep the position open or wish for them to liquidate it when the market session opens.  To keep the position open a trader would have to wire funds to the brokerage firm to bring the account balance back up to the initial margin again.  If the trader wishes to liquidate the position and not send any more money the broker will do this for you.  It’s a good idea not to send more money if you get a margin call.  Getting a margin call usually means the losses have exceeded your risk parameters and you are in the hoping and wishing mode that the market will come back to break even for you.  If your broker cannot contact you they will automatically liquidate your position for you.

There are no monetary penalties or fees due for a margin call other than the capital required to bring your account back up to the initial margin.

Once the trade is offset (bought or sold back) then the maintenance margin is then placed back in your trading account plus or minus any profits or losses and of course the cost of a commission per contract you traded.  This brings your buying power back up to 100% again.

Most brokerage firms will reduce your buying power for each order you have open on your trading platform even if the order has not been filled yet.  For many traders with smaller accounts this may mean they can only place one new position at a time.  Your protective stops, profit objective and entry price make up one order and would require margin for that order as soon as it is placed on your trading platform.

Using margin allows traders to control large amounts of capital with leverage.  Leverage can create some wonderful opportunities, but it can also cause excessive losses if a trader uses poor risk management.

“Success is the sum of small efforts repeated day in and day out.” Robert Collier

–  Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.