Understanding a Margin Call in Futures Trading
A margin call is a demand from a brokerage firm to a customer to bring margin deposits up to the initial or original margin levels to maintain the existing position. A margin call typically occurs when an adverse move against the customer's position transpires.
Margin serves as the good faith deposit that keeps an exchange's clearinghouse running smoothly. The margin call is the mechanism for the exchange that allows it to stay in business and act as the buyer to every seller and the seller to every buyer.
What Happens After a Margin Call?
If the value of your trading account falls below the maintenance margin level, a margin call causes the broker to require you as the client to deposit more funds to continue holding a position. If funds do not arrive promptly, the broker will likely liquidate enough a part or all of a position to eliminate the margin call.
Initial vs. Maintenance Margin
The Federal Reserve Board has set a rule called Regulation T, which determines the initial and maintenance margin requirements for trading. According to Regulation T, you must have an initial margin of at least 50 percent. You may, however, find that many brokers require closer to 70 percent.
In other words, you must pay 50-70 percent of a security’s purchase price with your own cash, and then the broker will provide the rest of the funds through margin. After your initial purchase, the brokerage firm sets a maintenance margin.
Regulation T requires a maintenance margin of at least 25 percent, although you'll likely find that most brokerage firms require closer to 30-40 percent. This means that on an ongoing basis, you must maintain equity in your account with a value of at least 30-40 percent of the total margin account value.
A customer trading a gold futures contract has an initial margin of $5,000 and the customer deposited $6,000 in their commodity trading account. The maintenance margin level on gold was $4,000. When the price of gold moves against the customer by $2,500 the account value drops to $3,500, below the $4,000 maintenance margin level by $500.
The brokerage firm the sends a margin call to the customer requesting a deposit of an additional $1,500 to bring the account back up to the initial margin level of $5,000. To meet the margin call, the customer will usually wire transfer funds into their account at the brokerage firm. If funds do not arrive on a timely basis, the broker will liquidate the position of the client, eliminating the margin call.
Customers Can Lose A Fortune
Margin acts as a loan or good faith deposit that allows a trader or investor to enter into a long or short position on a futures contract. However, the responsibility does not end there. When buying or selling futures, the person is not only responsible for the margin upfront; they are also responsible for the entire value of the contract if the market moves.
Commodities are risky assets, meaning that they have a great degree of volatility and less liquidity than stocks, bonds or currencies. It is not unusual for the price of a commodity to double, half or more in a short time.
Therefore, when trading futures contracts one must always be ready for a margin call at any time. Most Futures Commission Merchants (FCMs) require those with futures accounts to keep plenty of funds in their accounts in the case of margin calls.
A Movie Scenario
If you remember the movie from the early 1980’s Trading Places, the Dukes bought Orange Juice futures on the exchange because they thought the price was going up. When the price went lower, the President of the exchange came to the Dukes and said, “Margin call, gentlemen.” Since their long position was so big and the price went down so far, the Dukes could not come up with the cash necessary to support their long positions.
At that point, the exchange president said, “You know the rules of the exchange,” and he told his assistant something along the lines of, “Take all of the Dukes' seats on the exchange and sell the assets of Duke and Duke.” Although the movie was fiction, this is an excellent representation of what can happen when a trader or investor cannot meet a margin call.
Understanding Margin Trading
Make sure you understand all of the ins and out of margin before you open a trading futures account. Your broker is required to explain margins before trading commences. Additionally, to open an account to trade in the futures market there is a long margin document that you must sign. It is always a mistake to sign this type of document without understanding all of the responsibilities, definitions, and risks outlined in the document.
An FCM will provide this documentation to you and will make time to answer all of your questions. If you do not understand the documentation or if the broker or FCM does not take the time and patience to explain it fully and to your satisfaction, look for another who will. You can always check with the futures exchange, or CFTC is you have any questions, comments or complaints.