Margin Requirements Are Not Recommendations
Many consider the leverage involved with futures to be a blessing and a curse. There are few investing environments that will give an individual investor as much leverage as they can receive from an FCM and exchange — those responsible for setting margins. For example, one clearing firm we work with will offer clients $500 day margins on the E-mini S&P. This means that with as little as $500 dollars, a trader can purchase one E-mini S&P future — a vehicle that, at current prices, has a value of over $59,000 (current price x $50 per point). That would give someone a contract value to account value ratio of over 115:1 which essentially means that for every $1 in your account ($500), you are trading with $115 in borrowed funds.
Many go to the futures markets for that leverage alone. On a daily basis, it will be difficult to find a bank to loan you that kind of investment capital. Even in the leveraged ETF markets, you won’t find many products trading with more than 3:1. The leverage that exists in futures is seldom duplicated elsewhere.
With that said, it is important to know that minimum margin requirements are NOT recommendations for the minimum one should have in their account before entering a position. The margin requirements set by exchanges exists so that account holders, FCM’s, and brokerages have risk measures in place to protect against unforeseen movements and accounts going debit. For long term trading success, managing these margin levels is paramount.
How much is too much?
We’ve decided that 115:1 is too great of a leverage factor — using 100% of the liquidity in the account for initial margin is not recommended. How does one know what is recommended? That’s a tricky question. It will depend on the individual trader and the time they will hold the contract. In my opinion, a good general rule to consider is to keep the total contract value to liquidity ratio below 10:1 if holding overnight. That should give the account breathing room in case the markets move against the positions.
Another quick rule a trader can use to determine if overleveraged is the margin to liquidity percentage. This can be calculated by taking the amount of initial margin used by the account divided by the net liquidation value. For example, an account with $5000 dollars in net liquidity and an initial margin of $1000 will have a margin to liquidity percentage of 20%. I would encourage traders to keep their percentage below 50%. From a professional standpoint, most CTA’s I observe are around 30%. I think anywhere within that range can give you plenty of income potential while keeping the drawdowns manageable.
Keeping these numbers in mind can not only keep you in trades longer, but establish habits that can keep you solvent longer to avoid the dreaded margin call. Remember — this is a marathon, not a sprint. Keeping yourself in a trade so that you can experience a foreseen market move is as important as timing the move itself.
THE RISK OF LOSS IN TRADING COMMODITY FUTURES AND OPTIONS CONTRACTS CAN BE SUBSTANTIAL. THERE IS A HIGH DEGREE OF LEVERAGE IN FUTURES TRADING BECAUSE OF SMALL MARGIN REQUIREMENTS. THIS LEVERAGE CAN WORK AGAINST YOU AS WELL AS FOR YOU AND CAN LEAD TO LARGE LOSSES AS WELL AS LARGE GAINS.