November 2011

Key Messages: Securities brokerages apply discretion to determine the margin requirements for individual clients based on the latter's personal circumstances and the securities concerned. Brokerages providing trading services in futures contracts and options contracts can impose margin requirements for clients at or above the minimum margin requirements set by the clearing houses. Irrespective of the nature of securities and futures products, the margin requirements may change according to prevailing market conditions. Since brokerages are not obligated to make margin calls, your position even may be subject to forced liquidation without prior notice. Margin trading terms may be stated in client agreements. The onus is on you to look them up. Before trading on margin, consider your own financial situation, investment appetite and objectives.

A number of readers who read in the last issue of InvestEd Intelligence that margin calls are not obligatory in leveraged foreign exchange trading called or wrote to me. They were curious to know how trading on margin works in securities and futures. Not surprisingly, some complained against their intermediaries, asking:

• Why the brokerages close out their position without calling in advance;
• Why they have been asked to meet margin requirements on short notice; and
• Whether the brokerages could make changes to margin requirements without notice.

These readers apparently had some misconceptions about margin trading and the risks involved.

How the game is played

For securities trading, if you borrow money from your brokerage to raise the level of your investments, ie, accept margin financing, it is entirely up to the brokerage to determine your margin requirements on the basis of your personal circumstances and the securities collateral provided by you. In other words, your brokerage assesses your financial capability, as well as the liquidity and volatility of the securities collateral concerned. For instance, the margin ratios on blue chips are likely to be higher than on other stocks.

The rules of the game for margin financing of futures and options are relatively more complicated, however. The setting of margin requirements involves not just the brokerages but relevant clearing houses as well, which apply their own set of criteria to calculate the risk exposure, etc. Let me explain, using first the table below:

	Securities	Futures and options
Setting the margin requirements	At full discretion by brokerages	At the brokerage's full discretion, subject to the minimum levels worked out by relevant clearing houses
Time allowed to meet margin shortfall	Depends on the brokerage's own guidelines for various client profiles, amount of loan, etc	Depends on the brokerage's own guidelines Brokerages may be required by clearing houses to make up shortfall on short notice in times of high volatility, which may in turn request clients to meet their own shortfall urgently

Just to explain further, here are the key points:  

• Margin requirements

• For securities, only one party lays down the margin requirements, ie, individual brokerages.
• For futures and options, relevant clearing houses use established methodology to determine the minimum margins. However, out of prudence, brokerages usually set clients' margin requirements at higher than the minimum requirements set out by relevant clearing houses.

• Margin shortfall

• For securities, the brokerage determines the amount of time that you are allowed to make up the shortfall, depending on its own guidelines.
• For futures and options, the time allowed to meet the margin shortfall also depends on the brokerage's own guidelines. Relevant clearing houses normally review margin requirements at the end of each trading day. However, during periods of high market volatility, the clearing houses may make margin calls anytime during the trading day and request brokerages to settle intra-day margin within a short period of time, say an hour. In turn, the brokerage may give you only short notice.

No matter which product type, the margin requirements set by brokerages may change at any given time to match changing market circumstances. For instance, brokerages may reduce margin loans when the overall market heads south following an untowardly financial incident. 

Note margin call policy

Moreover, the margin call policy is not the same for all brokerages. Each brokerage has its own policy and the terms may be stated in the client agreement. Some brokerages may post their policies on their company web sites.

One common term is forced liquidation without prior notice if the value of the securities held or the level of funds in your account falls below the pre-set minimum margin level. Brokerages have no obligation to make margin calls. Hence, your position may be closed out without prior notification to you, particularly in times of extreme market volatility.

Furthermore, the position can be liquidated at the brokerage's discretion, which means at a price level or time not favourable to you. Even so, you still are liable to meet the margin shortfall in your account.

Think carefully before committing

Now you know, margin trading involves significantly higher risk than cash trading. Before delving into it, do an honest assessment of your own financial, investment appetite, experience and objectives to see if you can bear the additional risk.

In addition, read the client agreement to find out the margin trading terms, interest charges, margin ratio, margin call policy and the circumstances under which your position may be closed out without your consent. Seek clarification from your brokerage if in doubt.

Once committed, please monitor your position closely and reassess constantly your ability to maintain the position, particularly in times of high volatility. Don't hesitate to reduce the amount of your margin loan if you find it necessary.