A margin call is one of the phrases that scares a new futures investor the most. Often, they picture life savings getting wiped out in seconds, as it does in movies. The truth is not nearly as intimidating. Margin is simply a tool. One that educated investors often love. After all, if you expected your portfolio to provide a 10% return per year and could simply trade it with the same amount of money at twice the rate, you would be thrilled. Of course, this comes with the risk of doubling as well. Efficient use of capital can be the key to unlocking new opportunities. So, how does margin work, and how can you use it to your advantage?

“Margin is like a deposit”

I often tell people, “Margin is like a deposit.” If you were to reserve the newest Corvette, you might put down a deposit for a few thousand dollars ($5,000 for the newest ZR1!). This would control one car and give you the option to take delivery when it was ready, at which point you would pay the balance. In the same way, one S&P e-mini contract allows you to control 50x the level of the S&P. This means that each point the S&P moves makes or loses you $50. At the current level of 6465, this would mean $323,250 in exposure ($50×6465) to that index. Initial margin for that contract varies by brokerage but can range from $12,500 to $24,000 per contract, and maintenance margin would be about 10% less. More on this difference later. Thus, with a fraction of the capital, you could control a much larger portfolio.

Two mindsets: contracts vs. risk

This exposure is excellent when things go well, but things don’t always go as planned. Many retail traders might ask themselves, “How many contracts can I afford with the money in my account?” This differs wildly from professional traders who ask, “How much risk can I take per trade to ensure that I can be wrong for 100 trades?” Comparing the two approaches shows the basis for the scary reputation of margin calls. If an aggressive investor used all the capital in their account, they could get wiped out quickly due to their extreme leverage. Let’s look at an example.

Example: Aggressive vs. Professional

Aggressive Investor

  • $300,000 account
  • Trades 10 contracts with an initial margin of $20,000 per contract, using $200,000 total margin.
  • Total exposure is $3.23 million (6465x50x10=$3,232,500). 10.78X leverage ($3,232,500/300,000=10.78).
  • A 600-point drop in the index would be 9.3%. This would result in a $300,000 total loss.

Professional Trader

  • $300,000 account
  • Trades 1 contract with an initial margin of $20,000 using $20,000 total margin
  • Total exposure is $323 thousand (6465x50x1=$323,250). 1.078 leverage ($323,250/300,000=1.078)
  • A 600-point drop in the index would be 9.3%. This would result in a $30,000 loss.
  • Trader still has $270,000 for the next trade.

Note that in the example above, the professional trader only used a fraction of the funds available to trade. We cover more about why to choose these managers and how they chose these trade levels. When combining strategies, a good portfolio manager attempts to balance risk by mixing return profiles to allow for leverage. This is potentially a more conservative manner to avoid spikes in cash usage. This is called cross-margining.

Portfolio construction & cross-margining

A cross-margined portfolio can use any number of traders. If some carry more risk in volatile markets and others are less active in the same environment, the combination of the two should yield consistent margin usage. If we take any program and look at its peak usage, add in its biggest drawdown, and then add this total using the same formula across a portfolio, we should establish a “worst-case scenario” for the investor. As the collection of managers trade it is easy to see what “normal” cash usage looks like and over time, “extreme” margin. Often, a customer will take money out of the account or add managers without adjusting trading exposure meaningfully once they understand the somewhat predictable nature of the account.

How pros handle cash & margin calls

Professional trading firms will often put as little margin as possible in an account to support trading. They might be more comfortable leaving it in their bank account, using it for other investments, or limiting exposure to one firm holding the funds as a best practice. Naturally, they incur more frequent margin calls. When this occurs, they simply wire in more money to meet the need and then remove it when the spike passes. An example of how this works in practice is below.

Cross-margined portfolio example
  • $4,000,000 notional trade level
  • Manager A – $115k margin
  • Manager B – $415k margin
  • Manager C – $125k margin
  • Total Initial margin – $655k
  • Total initial margin with all managers combined – $620k ($35k less)
  • Total maintenance margin – $570k ($50k less than the combined initial margin)

The customer puts $1 million in the account and is $380k above the required initial margin and $430k above the maintenance margin. As long as they keep enough in the account to stay above their maintenance margin, they avoid a margin call. 

What a margin call looks like in practice

Tomorrow, after a large market drop, the maintenance margin spikes to $1.1 million. He would then be in a maintenance margin deficit of $100k. At this point, the investor would need to bring the account above the initial margin, which would be a bit higher at $1.2 million. They would wire in $200k (still $2.8 million below trade level) to meet the call. Your IASG broker would work with you and the FCM to make sure trading proceeded unaffected while the call was met. This typically needs to occur within 1-2 days. Once the account returns to normal, the customer can remove their $200k.

Bottom line

Contrary to what most assume happens, this is a calm response that results in either the call being met or lower trade levels and closed positions. This is not to say that things happen that go well beyond the scope of margin expectations, which might result in a much faster response. Good traders put systems in place to protect themselves from these dislocations. If the idea of a margin call is preventing you from considering a futures account, please reach out and talk to an IASG representative. We would be happy to lead you through the process and help you get started with a more conservative CTA until you get comfortable with the account requirements.

We look forward to helping you learn.

Photo by Bram Kunnen on Unsplash