TRADING LEVERAGE and mark to market
TRADING LEVERAGE:the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss
MARK TO MARKET: The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.
It is important for any trader to understand Trading Leverage and Mark to Market accounting. The MF Global situation has brought this to light this recently, but there have been many other similar situations such as the Long Term Captial Management fiasco in the late 1990's or more recently the excessive leverage assumed by Wall Street firms with mortgage securities. As a trader, Leverage can be your best friend.......or more likely, your worst enemy. It is well described in the Tradernovice common trading mistakes section.
Most new traders are surprised to learn about leverage, how commonly it is employed, and how easily it can be obtained. Most trader's initial response is to think about a recent SUCCESSFUL trade (the key is successful), think about how much he or she made, then think about how much he COULD have made, were he to have used leverage with the trade. The sky is literally the limit. A novice trader will look at his brokerage balance and then look at margin requirements for any given product, for example a futures contract, and he will then divide the account balance by that margin requirement to decide how many contracts he may trade. There are a few flaws with this thinking and that is where the term MARK TO MARKET comes in. We will get to that in a moment.
The first futures markets in the United States sprung up in the midwest. The Chicago Board of Trade notes its foundation as April 3, 1848, with the then governor William H. Bissell signing and approving a special charter for the Board of trade of the City of Chicago 11 years later. It was no surprise that this Board of Trade picked Chicago as its home, with the primary trading instruments being commodities, of which grains and livestock composed a large proportion. Chicago was central to many farming states and the great lakes provided the necessary transportation.
Farming has always been tricky business. It is not enough that grain farmers have to deal with soil conditions, insects, drought and the like, but they also have to decide how much to plant, which requires predicting demand. This is a difficult, if not impossible task. In the early 1800's a farmer may well plant, protect, and harvest his crop with expertise, only to find that when he transported it to the marketplace a glut had caused the price to fall to unprofitable levels. This lesson might then be learned all to well, causing few farmers to plant grain the following year and leading to severe deficits. What was a farmer to do?
The advent of the Futures markets allowed for farmers to plan. A forward contract could be arranged between the producer and consumer, thus specifiying an agreed upon price and date for future delivery. The contracts were tailor made to fit the needs of the two specific parties involved. Commodity involved, size of the order, and date of delivery were all negotiable. This worked well.....unless it didn't work. If price were to change significantly, either the producer or consumer would simply fail to abide by their contract. There had to be a better solution. With that in mind, came the formation of the Chicago Board of Trade.
The formation of the CBOT led to changes. No longer would the consumer and producer decide on specifics such as instrument and quantity and date of delivery. Contracts would be specified by the CBOT. In addition, initially the CBOT, and later Clearinghouses, would be responsible for contract settlements. Individuals who agreed to forward contracts would thus be bound by them.
Since futures contracts call for delivery at a later date, it is not always feasible and certainly not desirable for the purchaser, to have to pay for the to be delivered goods in their entirety on initiation of the contract. Though full payment up front was not desirable for the consumer, the producer (and later clearinghouses) had to be assured a contract would be honored and thus some significant up front downpayment was required. In 1865 the CBOT adopted a rule calling for 10 percent margin. This seemed to meet the needs of both parties, but at the same time allowed for speculators to gain the advantage of trading leverage, enhancing their ability to make profits, or to incur larger losses. Margin trading in stock accounts came at a later date.
Margin is defined as the total value of a security that the investor must pay in cash. The initial margin requirement for a stock or futures contract is determined by several factors. The Security Exchange Act of 1934 (enacted after verly low pre depression stock margin requirements) allows the board of governors of the Federal Reserve to set initial margin requirements. In addition to the requirements of the Federal Reserve, stock and futures exchanges, clearinghouses, and individual brokerages set their own margin requirements, which are often more strict than that of the Fed. You can see how Interactive Brokers, a leading brokerage firm worldwide, calculates margin requirements here. New traders are sometimes surprised to see that margin requirements for a specific contract may change, but they do. For the most part this is related to the brokerage involved, who will likely have differing margin requirements for holding a position during open market hours as oppossed to after hours. In addition other factors such as volatility will cause brokers to change requirements.
The Federal Reserve may demand end of day accounting for margin accounts. But for brokerage firms who allow the use of leverage, that type of accounting may be insufficient and therein they typically use real time margining. Herein the importance of understanding mark to market accounting, which is used in such situations.
For individuals who do not use margin or leverage in their trading, there is no need for mark to market accounting. End of day calculations will suffice in settling accounts. That is not the case with margin or leveraged accounts, which may not have sufficient funds for settlement were end of day accounting used.
Take for example the case of an individual who owns 10,000 shares of Microsoft. For the purposes of this discussion assume those shares were purchased at $25/share for an intial investment of $250,000. Were the market to suffer a severly bearish run, and the price of MSFT to drop to $15/share, the investor may simply take the approach that he has lost nothing until he sells. However ill advised this may seem, it remains his right. His broker, who believes the market will fall further, may explain that with MSFT now trading at $15/share, the individual no longer has a net worth of 250k, but instead his shares are only worth $150,000. Whether the investors agrees or not is his business. He may think that the fundamentals of Microsoft are so strong that the company is worth much more than the current trading price, and unfazed, may simply leave his investment as is. Those who handle the trades for the investor, the brokerage,the exchange, the clearinghouse, have no risk of loss should the price of MSFT continue to fall.
At this point we must consider a second investor who also purchased 10,000 shares of MSFT at $25/share. The difference is that this investor only had $200,000 to invest initially, so he had to employ trading leverage by borrowing $50,000 to purchase the stock partially on margin. Once the market has fallen, and the shares of MSFT have dropped to $15/share, this second investor has seen half of his investment disappear. His initial $200,000 is now only worth $100,000, for a loss of 50% (150k value of shares minus 50k loan). Like the first investor, he too may feel great about the fundamentals of MSFT and want to keep his investment, but the clearinghouse, his broker, the federal reserve and the exchange, may not feel so great about the fundamentals of the investor. With his net worth now only 100k, these outside interests risk losing their own capital should the price of msft continue to fall and and the investor not be able to pay off his debts. Thus, each of these outside agencies require Mark to Market accounting. This simply means that at any given minute, the net worth of the investor's account will have no relation to the stock price in the initial transaction, but instead will be determined by the current value of holdings in the account. This is determined by a formula utilizing bid/ask/last trade values, the calcualtion of which varies by instrument and market, but in most cases last trade value should be a close approximate. The idea is that the third party (broker, exchange) values the account based upon current liquidation value. What could they get if they had to sell all holdings NOW? Should MSFT continue to fall, the investor will get a "margin call" and be asked to deposit more money in the account. Should he not be able to do this, he will be asked to liquidate shares, or it will be done for him. By using Mark to Market accounting in real time, risk to third parties is considerably reduced. By purchasing shares on margin, or using leverage, the investor has substantially increased the risk of his position.
It is Incredibly important that traders understand the risks inherent in using trading leverage. Because traders always see trades from the optimistic point of view (if not ...you would not take the trade) they also tend to view leverage the same way, as an instrument that can magically increase profits. But I would suggest another analogy. Consider a drive up a narrow passage along the side of a mountain in a third world country. The road is paved, but poorly maintained, and there are no side rails, or safety barriers between road and deep ravines below. You traverse such a road on the way to a specific destination. You have a worthy vehicle (you think), and you desire to get to the destination quickly. Margin and leverage in the markets is like speed in this analogy. You may drive extremely fast and arrive at your destination quickly, but the faster you drive, the more likely a terrible outcome. A slight miscalculation at a slow speed (without margin) will have consequences, but they may be mild. The same miscalcualtion at a high speed (with leverage) may end your life (or trading career).
One last point important for nomenclature only is that when a trader initiates a futures trade his initial payment is via the use of a performance bond, which represents only a fraction of the total contract price. The price of such a performance bond is established not by the broker, but by the exchange. This allows the trader to control a large contract with a small amount of capital. It is similar to a downpayment. Buying stocks on margin however, is simply the borrowing of capital from the traders own brokerage firm to allow him to make the trade. Margin actually refers to the minimum amount of cash or securities that must be held in the trading account in order to allow the particular trade to occur. Thus, when the value of equity holdings fall, the investor gets a margin call, which is a call for more cash or securities in that specific account. The terminology used with futures accounts and stock margin trading is different, the implications are not .
Buying Power in leveraged accounts
A question came up with one trader about buying power in margin accounts. What is it? How is it calculated?
Essentially buying power is equal to the cash and securities available in a brokerage account,
Wall Street Survivor has an explanation listed here. They calculate buying power as follows:
Euity + Cash - Debit balance (borrowing)- 2*margin requirements= buying power.
I trade with Interactive Brokers. There buying power formula is as follows:
Buying Power represents the day trading leverage that a Reg T margin account has available. The buying power figure is arrived at using the following equation:
(Lesser of: Equity With Loan Value or Previous Day Equity With Loan Value) - Initial Margin)*4