The margin call is a requirement from a brokerage firm for a client to deposit funds into the original margin or equity to maintain their current position. A margin call typically occurs when a negative move against the client’s position causes a significant drop in the value of their account.
What happens after a margin call?
If one or more of the assets in your account decline to a level that reduces your trading account balance below the maintenance margin level, your broker will issue a margin call. This is a way to compel you, as a client, to deposit more money into your account to maintain the position. (You can also sell some of your assets so that the funds return to the margin status. However, this is not a common option.)
If the company does not receive your funds in a timely manner, or if you are simply unable to pay, the broker may have to liquidate some or all of the positions in your account to stop the margin call. This is also referred to as “forced selling,” which is a right that brokers have to protect their accounts when dealing with large profits and losses that may occur when betting on borrowed money.
Initial margin vs. maintenance margin
The Federal Reserve has established a rule called Regulation T, which sets limits regarding margin in futures trading: the initial margin and the maintenance margin. The initial margin is the cash amount you must hold in reserve to initially purchase a stake in a futures contract. The rule states that you must have a cushion of at least 50% above the sale price. Brokers and firms can set their own limits, as long as they meet the law, so you may find that many brokers require around 70%.
In other words, you must pay 50% to 70% of the purchase price of the futures contract with your own cash, and then the broker provides the remainder of the funds through margin. After the initial purchase, the firm sets the maintenance margin. This is the cash amount (or cash-equivalent assets) that you must keep in your account or on hand in case of a margin call.
Regulation T specifies that the maintenance margin must be at least 25%, although you will find that most firms set it closer to 30% to 40%. This means that on an ongoing basis, you must hold rights in your account amounting to 30% to 40% of the total account value on margin.
Margin call in action
Suppose you are trading a futures contract for gold with an initial margin of $5,000 and you deposit $6,000 into your commodities trading account. The maintenance margin level on gold is $4,000. When the price of gold moves against you by $2,500, the account value drops to $3,500. This number falls below the maintenance margin level by $500.
The company will then send a margin call requesting you to add $1,500 to your account to bring it back to the initial margin level of $5,000. If the funds do not arrive quickly enough, the broker will liquidate your position and end the margin call.
Note: To meet a margin call, you have several options to transfer funds to your account, but most people prefer wiring the money to the company.
Traders can lose a fortune
Margin acts as a loan or a trust deposit that allows a trader to take a long or short position on a futures contract. However, margin alone is not sufficient protection for traders for most people. Therefore, the obligation does not end here. When buying or selling futures contracts, you are responsible not only for the margin provided but also for the total value of the contract if the market moves.
Commodities
They are risky assets, meaning they have a high degree of volatility and lower liquidity than stocks, bonds, or currencies. It’s not uncommon for the price of a commodity to double or be cut in half or experience another extreme change within a short period of time.
When trading futures contracts, you should always be prepared for a margin call at any time. Most futures commission merchants (FCMs) require those with futures accounts to keep a significant amount of money in their accounts in case of a margin call.
Margin Call on the Big Screen
If you remember the movie “Trading Places” from the early 90s, the Dukes bought futures contracts for orange juice on the exchange because they thought the price would go up. When the price dropped, the exchange president came to the Dukes and said, “Margin call, gentlemen.” Because their long position was large and the price dropped significantly, the Dukes couldn’t provide the cash that was required to support their long positions.
At that moment, the exchange president said, “You know the rules of the exchange.” He told his assistant something to the effect of, “Take all the Dukes’ seats on the exchange and sell Duke and Duke’s assets.” Although the movie was fictional, it serves as a very good model of what can happen when a trader cannot meet a margin call.
Before You Start Margin Trading
Make sure you understand all the details of margin and margin calls before you open an account to trade futures. Your broker is required to explain margin before you start trading, so you should hold them to that obligation if you have any doubts. Also, when you open an account to trade in the futures market, you will be required to read a long document that outlines the risks and specifies all terms of the account, including margin.
Note: If you encounter any issues when setting up a new account for futures trading, you can always check with the futures exchange or the Commodity Futures Trading Commission (CFTC) if you have any questions, comments, or complaints.
Your broker or FCM will provide you with this form. This person will also have time to answer all your questions. On the last page or on a new form, you will have to sign a contract certifying that you have read it in full, understand what it means, and are ready to comply with the terms and bear the risks. It is never advisable to sign your name if you do not fully understand all the terms, obligations, and risks outlined. If any part of it confuses you, or if the broker or FCM does not take the time to explain it fully and to your satisfaction, seek someone else who will.
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