margin calls

When I looked at my Fidelity account this morning I saw two odd things:  a simplified interface, and a message sent to everyone with a margin account (my wife and my joint account with Fidelity is a margin account, although we don’t trade on margin).  The message was essentially a warning to be on the alert for potential margin calls.

I’ve never seen this before.  A caveat:  until I retired at the end of 2006 all the family money was in the mutual funds I was managing, in whatever vehicle my employer required.  Still, I didn’t see this in 2008-09.

Two conclusions:

–Fidelity is anticipating/seeing volume increases that are testing the limits of its software (probably mostly an issue of private-company-esque aversion to spending on software infrastructure)

–more interesting, aggregate equity in the accounts of its margin customers must be dangerously (for the customers) low.  Margin-driven selloffs are typically ugly–and very often mark a market bottom.  Here’s why:

margin trading

In its simplest form, a market participant establishes a margin portfolio by investing some of his own money and borrowing the rest from his broker.  He pays interest on the margin loan (Fidelity charges 5% – 9%+, depending on the amount) but all of the gains/losses from the stocks go to him.  The client does relinquish some control over the account to the broker.  In particular, the broker has the right to liquidate some/all of the portfolio, and use the proceeds to repay the loan, if the portfolio value minus the loan value falls below specified levels.

Before liquidating, the broker tells the client what is going to happen and gives him a short period of time to put enough new money (securities or cash) into the account to get the equity above the minimum amount.  This is a margin call.

If the client doesn’t meet the call, the broker begins to sell.  The broker has only one aim–not to get the best price for the client but to convert securities to cash as fast as possible.  Of course, potential buyers quickly figure out what’s going on and withdraw their bids.  Carnage ensues.

That’s what Fidelity was saying we’re on the cusp of this morning.

There are some very shrewd and successful margin traders.  Around the world, though, retail margin traders are regarded as the ultimate dumb money.  That’s why seeing forced selling from these portfolios is typically seen as a very positive sign for stocks.




the Chinese stock market now

declining stocks

Until about a month ago, Chinese stocks were soaring.  Over the prior year the main indices in both Shanghai and Shenzhen were up by about 150%.

Since then, however, both markets have been in a continuous tailspin, dropping a quarter of their value.

Beijing has just announced emergency stock market stabilization measures aimed at halting the fall, on the idea that swooning stocks will hurt capital formation (duh!) and clip a percentage point or more from economic growth–at a time when China doesn’t have that many points to spare.

What’s going on?

As part of its plan to gradually modernize its equity markets and ultimately open them to the outside world, China introduced margin trading (as well as stock index futures and short-selling) domestically in 2010.  China is now going through what all emerging markets eventually do–its first full-blown margin trading crisis.

margin trading

There are lots of ins and outs to margin trading, but it’s basically using the stocks you own as collateral for loans to buy more shares.  It can be very seductive when stocks are going up.  And it’s immensely profitable for brokers.  So it’s not surprising that margin loans are easily available to lots of customers.  Also, in many emerging markets, China included, it’s relatively easy to circumvent restrictions on margin lending by arranging bank loans collateralized by stocks that may not technically be margin borrowing, but effectively are the same thing.

The key aspect of margin trading is that the value of the securities in the account must exceed the margin loan total by a certain safety amount.  If prices fall to the extent that the safety amount shrinks, or is wiped out, the broker has the right to sell enough securities from the account to restore it.  He may call the client and give him the opportunity to add more money to the account   …or he may just sell.

However, this selling itself depresses prices further–eroding the value of the remaining securities in the account as well as any safety amount that may be built up.

Also, margin traders around the world tend to be both the ultimate dumb money and the ultimate herd animals.  They all but the same speculative stocks and they (almost) all leverage themselves to the eyeballs. Even if customer A is initially in fine shape, the selling in the accounts of customers B,C and D will pressure the margin balance of A as well as their own.

The first selling, then, tends to create an accelerating cascade of more selling that’s extremely hard to stop.

This is what China is experiencing now.  This is also why the government has stepped in with a massive market support operation to try to staunch the flow.

effect on the rest of the world?   …especially you and me

The Stock Connect linking mechanism between Shanghai and Hong Kong–aimed a diverting funds away from soaring mainland stocks–is now exporting the mainland weakness in much milder form to the Hang Seng.

Beijing has a ton of money and its stock markets are, realistically speaking, still not very open to the outside world.  As the current anticorruption campaign shows, the CCP has lots of ways to punish people who do stuff it doesn’t want.  So I imagine that the government will stop the downward stock market momentum.  The big questions are:

–how long will it take, and

–how large an unwanted portfolio of stocks (which will act as an overhang on the market) will Beijing have to purchase in order to achieve the stabilization it wants.

My answers are:

–I don’t know, but probably not more than a couple of weeks, and

–I don’t care, because I think the way to play a potential rebound from oversold levels is through the Hong Kong stocks now being sold by mainlanders.

commodities trading and margin: why volatility now?

commodities vs. stocks

Early in my career internationally, my boss gave me the assignment of studying the palm oil and soybean markets as a step in taking over responsibility for investing in the publicly traded plantation companies in Malaysia.  One of my first stops was a visit to the head of commodities trading for Merrill Lynch in Chicago.

It was like stepping into a parallel universe.

As an equity investor, I talked about remaining calm, not acting hastily and doing thorough research.  He talked about being in tune with the rhythm of the markets, reading the charts, developing good instincts, making decisions on gut feel and having lightning reflexes.  I spoke about hiring professional researchers; he said he looked for good high school or college athletes, regardless of academic accomplishment.

margin differences

Why the difference in outlook?  It may have something to do with the difference between dealing with global demand for natural raw materials vs. the actions of managers in highly complex, but focused, corporations.  But I think it has mostly to do with the, by equity standards, extraordinarily high levels of margin leverage that commodities market participants routinely employ in their investing/speculating.  It’s cold comfort to have the long-term trend absolutely correct but to be wiped out by a 10% price fluctuation in the wrong direction later on this week.

other quirks (from an equity investor point of view)

Two other characteristics of commodities trading to note:

–exchanges typically set the margin rules

–exchanges also typically set maximum daily price movements, both up and down, for a given commodity.  One consequence of this is that there are days when the price moves to the upper/lower limit without any sellers/buyers appearing.  In this case, the market can close for the day at limit up/down, but no trade.  So you can be “trapped” in a position you want to liquidate but can’t.  Another reason to act fast on new short-term developments.

greater interest in commodities

In recent years, there’s been a lot more interest in commodities than previously.  I see several reasons for this:

–the rapid economic advancement of countries like China and India, with large populations and at a stage of development where they use increasingly large amounts of farming and mining commodities.

–the rise of hedge funds, many of which are run by traders who are familiar with commodities and who are more comfortable “reading” charts than researching companies.

–the development of exchange-traded funds based on commodities, which give individuals easy access to commodity investing they didn’t have before

–the end to almost two decades of gigantic, price-depressing overcapacity in most mineral commodities created by overdevelopment in the late 1970s- early 1980s

–the increasing complexity of finance and the concomitant development of financial derivatives.

what’s going on now?

Why the sharp recent decline in mining and food commodities?

As I mentioned in my post yesterday on margin in general, a margin call can happen in two ways:

–either the value of your account can fall below the minimum margin level, or

–the market regulators can raise margin requirements.

margin requirements rising

The second hit the commodities markets late last month.  As the New York Times reported recently, that’s when officials at the CME (Chicago Mercantile Exchange) became concerned about the near doubling in the price of silver over the prior half-year.  The CME  immediately increased in the margin requirement for silver contracts.   When that had no immediate effect on the silver price, the exchange announced a series of increases that would rapidly bring the first-day margin needed to support each contract to $21,000+.

Each silver contract is for 5,000 ounces, or about $235,000 at a $47/oz. price.  Prior to these actions, the required first-day margin was $12,000-, meaning a market participant could leverage himself by 20x in buying silver.  (Actually, the allowed leverage was higher, since maintenance margin is lower than first-day, and because exchange members are permitted to use more leverage than speculators.)

Silver now trades for $34/oz., a decline of almost 30%, mos of the fall occurring in the first week after margin requirements were changed.

Other commodities have followed suit, though not to the extent of the decline in silver, as regulators have lifted margin requirements for them as well.

why act now?

Maybe the CME is just doing its regulatory duty.  A cynical person might speculate–à la the Hunt brothers–that pressure came from exchange members on the losing side of the trade.  Another (better, I think) guess is that there was pressure from Washington, where a new regulatory framework for commodity trading is now being developed.

margin trading

I want to write about two related topics:  what’s going on with violent gyrations in commodities markets (tomorrow) and the more general issue (Wednesday) of whether speculation can be destabilizing as well as stabilizing (academics deny the first is possible).  Today’s post on margin trading lays a foundation by discussing the tool–financial leverage–many speculators use to try to enhance their returns.

the basics

what margin is

In its simplest form, a speculator/investor trades on margin when he borrows money, usually from the broker or other counterparty he is transacting with, to buy securities.  He uses the value of these securities + additional cash or securities he has on deposit with the counterparty, as collateral for the loan.

Margin trading is a global phenomenon, both in the sense that it occurs in all the countries I’m aware of where securities are traded, and in the sense that it occurs over different classes of securities–stocks, bonds and commodities.  The precise rules and regulations differ from country to country, and the mechanics may differ in a given country, depending on the type of security.

the margin calculation

The ground-level calculation in margin trading is the “margin,” or net collateral, figured as a percentage of the gross collateral.  That is:

(value of the collateral in the account minus the amount of loans secured by the collateral)  ÷  the value of the collateral.

For example, if I deposit $10,000 with my broker, borrow another $10,000 from him and use the money to buy $20,000 of XYZ stock, I am trading on margin of 50%.   ($20,000 in securities – $10,000 loan  =  $10,000 ) ÷ $20,000 value of XYZ shares  =  50%.

minimum margin requirements

Typically, a country’s central bank or some other finance-related authority sets out a general framework for margin trading in stocks and bonds in that country.  A commodities exchange may serve the same function.

Some countries actively change margin requirements as a tool of economic policy.  The US did this in the early twentieth century, but not today.  (The Federal Reserve has a curious formula for stocks.  Generally, margin must be at least 25% (maintenance margin); however, on the day of purchase, the margin for new buys–but not the account as a whole–must be 50% (first-day margin).)

While your counterparty can’t offer easier credit terms than the general guidelines allow, it can, and usually does, set more stringent requirements.

Things also get more complicated if you have both long and short positions.  But in this post, I’m not going to worry about that.


Not every security can be used as collateral.  Typically, small capitalization or illiquid stocks, or stocks traded on foreign exchanges, are not marginable. 

what makes it attractive

For the broker, the answer is easy.  He makes a spread between his cost of funds and the broker loan rate, what he charges you in interest on your margin loan.  In addition, he earns more on the additional trading you do.  And he typically can earn fees by using your collateral in securities loan programs.

The investor/speculator can leverage his insights into securities markets with a larger pool of investment funds, provided the ideas earn more than the interest payments on the borrowed money.

Guess who usually gets the better side of the bargain?

margin calls

What happens if the margin in your account falls below the minimum requirements?

It’s important to note that this can happen in two ways:

1.  your stocks can decline in value, and/or

2.  the margin requirements can be changed, either by the regulator or by your broker.

The popular perception is that a margin call means that someone reaches you by telephone, tells you that your account has dipped below the minimum margin requirement and gives you time to add enough new collateral to restore your margin to the minimum level.

Notifying you, or even attempting to notify you, however, is not a legal requirement, at least in the US.  In fact, in the margin agreement you sign, you acknowledge that you understand the broker can change margin requirements without letting you know, and that he can sell securities in your margin account to repay enough of your margin loan to restore the minimum margin–again without notifying you.

If your broker begins to sell securities in your account, you have no control over which ones he sells.  Because his primary obligation is to protect his firm from facing a loss on its margin loan, he will typically sell as much as he can as fast as he can.  In other words, the most liquid stocks go first and he won’t spend a lot of time “working” the order to get the most favorable price for you.  Nor will he let you set limits.

From watching from the sidelines, I can tell this is not a pleasant experience.

Even worse, if your entire securities account is liquidated in the process, but there’s still a loan balance outstanding, you’re obligated to pay this as well.

On that cheery note, I’ll end for today.  Commodities tomorrow.