Hey everybody, it’s Michael Martin. Thanks again for being here. So the next question that came in was like, can you speak to margin to equity as a ratio? So a lot of folks look at, alright, let me give you some context. If you are a commodity trading advisor and you have 15%, so a million dollar account, you have $150,000 committed to margin for systematized CTAs, you would be, I would think, towards the upper boundary of committing margin. Because when that all that margin means is it’s 15% of notion of a notional value. So the question then becomes, if you had a million in cash, what is the actual notional value of what it is that you’re trading? Because therein to me is a good measure of leverage. It’s not just the fact that you’re putting down 18 K to trade one of the nqs, for example.
It’s what is the notion of value work out to be based on the amount of money that you have in the account because the margin is controlled by the exchanges and they use a SPAN calculator that takes into account liquidity and also volatility, and then they set what their margins are, they can change it at any given moment. The fcms and the clearing members can then use those as the lowest number. Sometimes they make them stronger, but they can’t go lower. So unless there’s some funny politics going on, there’s really no way to say, well, you’re going to take trade the NQ and take it home with you that you cannot have 18,000 a margin. Now if you create spreads, you’re simultaneously long and short the same instrument if two different extra expiration months. So for options folks, it would look like a calendar spread, right?
So that lowers your margin. Why? Well, because you’re simultaneously long and short, the same instrument of different expiration months. So they’re highly correlated. This is what Bruce Covner did if you read about some soybean trades in market wizards is he realized that I think it was the July, November bean spread was acting and trading like an outright so cleverly he decided to put on the spread because he could put more contracts on why? Well, because spread margin might be only 10% of what the directional outright for one contract would might be. So if I’m long, long July, short November, that might only be $1,800. If I was going to trade July long on itself might be 18,000. So he was like, I can put on 10 spreads as opposed to one outright and have the thing net perform like I’m 10 directional units. I wouldn’t recommend doing this.
He ended up giving back quite a bit of money in doing it, but it was a good learning, a good learning situation. So when someone asked me again about one of my better trades, I found myself in a spot where I had an account that I think it was like a 401K rollover thing. It was like 50 K and I traded some sugar. I was trading much larger. I think the account had an almost 40% draw down. Now I think I had maybe 30 million in client assets at the time. I had over 10 years of trading experience. I had already been in the trading tribe, for example, and I think in 2004 I was ranked number one as far as emerging CTAs. I don’t know if they were emer established CTAs at the time, but I was doing as well as I could possibly do.
All my pistons were firing in the right direction. I was trading again very large, and I remember there was a time when in that sugar trade in the early part that I had, I don’t know X amount of contracts, I was in a 40% drawdown. So the 50 K was 30 K and of the 30 k, 20,000 was cash and 10,000 was unrealized gains and sugar. So it was a good, I’ll do a case study on it one day, but it it’ll be in order to do it right, it’s going to be like four hour program and I don’t have the time for that right now. But when you see the confirmations, which I st, I still have from my clearing member, which was Edn F Man at the time, you’ll see I’m taking lots of small losses, small losses, small losses, small losses. I just got a big number of them in a row.
So you figure if you’re trading 2% risk units and you have net 20 losers, you can see where your drawdowns are going to come from despite some of the gains. So you go to school on yourself, you’ll learn. This kind of helped me to cut my thing that I talked about yesterday so that I wasn’t losing as much money. It also showed that you got to pull your weeds and let your flowers. There was no reason to sell the sugar because it kept going up. And so I didn’t emotionally want to go for that win. Now at the same time, I was fully loaded. I probably had 50% of my account balance was in margin to hold those sugar trades. So the margin to equity ratio isn’t necessarily a risk management tool because I was not risking 50% of my capital. I was never going to let that the sugar long position go against me to take out all of my margin.
What your margin is, just like Mickey’s finger, when you go to Disneyland, it says you got to be this tall to go on the ride. So you have to meet the standard. And that’s just because the exchange, knowing the volatility and the volume or what they estimate to be the liquid, you find out volume isn’t liquidity the hard way. So they figure out, okay, what the numbers are because they want the market to have integrity at all times. So if they let somebody in who’s too small or if they don’t put exchange limits as to the number of contracts that you can have on the same side of the market,
Which would be long futures, long calls, and short puts and aggregate all that you might find the marketplace itself doesn’t have the most integrity because any one player could either really screw things up or take advantage of and push the market around, at least on the future side. Remember, it’s the cash market that drives futures not the other way around despite what you hear from the politicians. So you cut your position size, you want to be mindful, right? Because you can’t buy more contracts than cash that you have. But mind you, the way the accounting works at the fcms because somewhere, somewhere, somewhere, no matter who you’re using, the money is custody that an fcm and then they mark everything to the market. So now you have a big position, 50% of your cash is in margin. As that contract goes up and up, your open equity, your open trade equity increases and that creates more buying power.
So your risk isn’t on or necessarily the margin that it requires to hold a big position. Your risk is the distance between your entry and your exit multiplied by the number of contracts and getting to that spot is an art and a science onto itself. If you’re using ATR based system, it’s all calculated for you. The volatility takes into account the dollar amount and the percent of your account that you’re willing to risk and it calculates everything right down to a T based on the volatility again and the amount of money that you want to risk on your account.
So to give you some context, say you had a million dollars in your account and you are risking one half of 1%, so 5,000 bucks. I think if you look at the 20 day ATR on the nq, the big NASDAQ futures contract, and I’m not saying to buy it or to sell it. I think the volatility on that using the 20 day ATR is about 5,200 bucks. Call it 5k. Now, if you are running a strict system and said, I have a million dollars, I want to risk one half of 1% and you took the ATR and you multiplied it, I think the multiplier is what, 20? It would come in at 5,200, but 5,200 is greater than 5%. So the amount of contracts in your risk unit at one half of 1% would be zero. And that’s doing it strictly and very puritanically using that model.
If you’re like, okay, it’s close enough, I can buy one contract that’s 18, right? Thousand dollars as margin. So it’s almost 2% of a million dollars to control one contract, and if it moved one ATR against you, that would be 5k. That would be your daily limit. So I don’t know if 2% is a lot or a little to you of a million dollars for example. So suppose you had a bunch of different contracts across several instruments and you edit all that up. Then you also might have stocks and regulation T. So I think your margin equity ratio is something you want to be mindful of, but I don’t necessarily, it’s not a tool that’s going to help you manage risk in a very long-winded way, right? Because there’s lots of ways you can look at it to try to say, what information or data can I glean from this and use to my benefit?
I have never been able to use margin to equity to know and to say this is a big position or it’s a small position. Two margin values can increase overnight. And even though you have the cash, so say you have a million dollar account, you get a hundred K in margin, one contract might go completely berserk and so they up it from say five to 8,000 per contract. Since you have so much, much excess cash, you’ll just see now you have 150 or whatever the number would calculate to in terms of committed margin. It doesn’t change where your stops are. I will say this though, and this is kind of related but not related. If you find yourself where you’re close to getting a maintenance call, you never want to add money or try to create a spread on a situation, don’t get cute, especially if you’re kind of newer to the game, which means for me, less than 10 years, when you think of how market cycles work, six months, a year, three years, not enough time, it definitely matters, but it’s not enough time to get a full or to really thicken your skin.
So if you put yourself in a spot where there’s a maintenance call on your equity, you have to offset contracts. Or if the exchange came, comes in and then your clearing member comes in and they increase the margin substantially for your position, then by all means cut it in half or more if you need to bring that number down. Certainly if the position is losing you money and you find yourself coming into a maintenance call, the best thing to do is offset the position. Don’t ever meet a margin call with cash or add even other securities to your account. Always just offset what’s losing you money. I know it’s, it’s not really related, but it’s kind of related as we’re having this discussion here on margin to equity and this and that. So anyway, hope this helps. Hope that answers the question. I think you probably knew a lot of this inherently, but if not, might be good to hear it. And as always, thanks for being here. Please consider liking and subscribing. Leave a comment if you want. Cause I look at everything and it gives me good feedback on what I’m doing and what your concerns are. This question actually came from a comment, so this is one way that we can kind of have an ongoing conversation and keep things moving, hopefully in a direction that’s meaningful for you on the channel. All right, appreciate y’all being here. I’ll see you tomorrow.
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