Understanding a Margin Call in Futures Trading

A margin call is a demand from a brokerage firm to a client to bring margin deposits up to the initial or original margin levels to maintain their current position. A margin call most often occurs when there is an adverse move against the client's position, causing a major drop in the value of their account.

Margin serves as the good faith deposit that keeps trades on the exchange running smoothly. It is a set amount that you, as the client, must have in reserve to assure the firm and outside parties that it can back up the debt it may incur through trades and if the market drops. The margin call, in effect, is a handy tool the exchange can use that allows it to stay in good esteem, to keep things moving, and to act as the buyer to each seller and the seller to each buyer.

What Happens After a Margin Call?

If one or more holdings in your account suffer a decrease to the point where the value of your trading account falls below the maintenance margin level, your broker will issue a margin call. This is a way to mandate that you, as the client, deposit more funds into your account to keep holding a position. (You could also sell some of your holdings so that the status of the fund settles back within the margin. This is not a common choice.)

If the firm does not receive your funds in time, or if you simply cannot pay, the broker may have to liquidate some or all of the positions in your account to stop the margin call. This is also called a "forced sale," and it is a right that brokers have to protect their accounts when dealing with the major profits and losses that may occur when leveraging their bets on borrowed funds.

Initial vs. Maintenance Margin

The Federal Reserve Board has set a rule called Regulation T, which sets two limits that relate to margins in futures trading: the initial margin and the maintenance margin. The initial margin is the amount of cash you must have on reserve in order to purchase a futures stake in the first place. The rule states that you must have at least a 50% cushion 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 closer to 70%.

In other words, you must pay 50% to 70% of a future'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 firm sets a maintenance margin. This is how much cash (or assets close to cash) you should have in your account or on hand in case of a margin call.

Regulation T mandates a maintenance margin of at least 25%, although you'll find that most firms set it closer to between 30% and 40%. This means that on an ongoing basis, you must maintain equity in your account with a value of at least 30% to 40% of the total margin account value.

A Sample Margin Call in Action

Suppose you are trading a gold futures contract with an initial margin of $5,000 and you deposit $6,000 in your commodity trading account. The maintenance margin level on gold was $4,000. When the price of gold moves against you by $2,500, the account value drops to $3,500. This falls below the $4,000 maintenance margin level by $500.

The firm will then send out a margin call to request that you put an extra $1,500 in your account to bring it back up to the initial margin level of $5,000. If funds do not arrive fast enough, the broker will liquidate your position and end the margin call.

Traders Can Lose a Fortune

Margin acts as a loan or good faith deposit that allows a trader to enter into a long or short position on a futures contract. But margin alone is not enough to safeguard trades for most people. So, the duty does not end there. When buying or selling futures, you are not only responsible for the margin upfront, but also 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 unheard of for the price of a commodity to double, half, or suffer some other extreme change in a short time.

When trading futures contracts, you 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 case of margin calls.

A Margin Call on the Big Screen

If you recall the movie "Trading Places" from the early 1990s, 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 that was needed to support their long positions.

At that point, the exchange president said, "You know the rules of the exchange." 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 a very good model of what can happen when a trader cannot meet a margin call.

Before You Get Into Margin Trading

Make sure you have a handle on all of the ins and out of margins and margin calls before you open a trading futures account. Your broker is required to explain margins before you start trading, so hold them to this duty if you have any doubts. Also, when you open an account to trade in the futures market, you will be asked to read a long document that defines the risks and states all the terms of the account, margins included.

A broker or an FCM will provide you with this form. That person will also make time to answer all of your questions. On the last page or on a new form, you'll have to sign a contract to attest that you have read it in full, know what it means, and are prepared to meet the terms and take on the risk. It is never advised to sign your name if you don't fully understand all of the terms, duties, 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, look for someone else who will.