The success of your futures trading strategy relies on how accurately you can calculate risk and how skillfully you use your leverage.
A futures contract is a highly leveraged financial derivatives product. While the added leverage boosts the trader’s capital efficiency, it can also lead to significant losses. Two ways that astute traders manage their use of futures leverage are through the margin to equity ratio (ME) and the margin equity percentage.
Margin, or what’s borrowed from a broker to make an investment, equals the difference between the total value of an investment and the loan amount.1 Therefore, margin trading, or “buying on margin,” means investing this borrowed money, which allows you to use leverage to up the stakes. For this purpose, often a trader will open a margin account—a type of brokerage account that uses borrowed money to purchase securities.
When trading on margin, investors must adhere to a standard set of margin requirements, two of which include the initial margin and maintenance margin. In other words, the broker requires the investor to have a certain amount in their account to open or maintain a position with a margin loan.2
The ME is the percentage of margin requirements with respect to account equity. It’s calculated using the following formula:
Required Margin ÷ Account Balance = ME
Also known as the margin account ratio or the safe leverage ratio forex (also referred to as “safe leverage futures” or “safe leverage stocks”),3 ME gives traders a good idea of their risk exposure.
To illustrate, assume that Erin the day trader buys one lot of E-mini S&P 500 futures. Given an account balance of $5,000 and the E-mini S&P’s intraday margin of $500 per contract, Erin’s ME is 1/10 ($500 ÷ $5000). This is a solid value and gives Erin several advantages, including:
Another way that Erin can measure risk exposure is with margin equity percentage.4 Essentially, this is another way of looking at ME. Let’s say that Erin is trading the same $5,000 account and buys two December E-mini S&P 500 contracts. Erin’s equity percentage becomes 20 percent: ($500 × 2 lots) ÷ $5,000.
As you can see, the financial markets have a language all their own. To better navigate these nuances and finetune your trading strategy, it helps to know which questions to ask.
Equity is the amount of money one has in their trading account at a given time (while trading orders are active). It is the calculated aggregate value of the trading account and becomes a trading balance after all trades are closed and finalized.
Margin equity is the amount of money in one’s trading account after considering any fees and accounting for the unrealized P&L of open positions.
Equity percentage is the trader’s equity divided by the account’s notional value.
Margin level percentage is the trader’s equity divided by their used margin: (Equity ÷ Used Margin) × 100. In the example above, Erin’s margin level percentage when buying two lots of E-mini S&P 500 is 500 percent: ($5000 ÷ $1000) × 100. Generally, values under 100 percent are prohibited. This is evidenced by the equity percentage limits and the futures margin requirements that TD Ameritrade and Thinkorswim require of their clients.
Net liquidating value is the monetary worth of the trading account if all positions are closed at the current market price.
The stock margin ratio is the equities trader’s available margin with respect to their account balance. In the U.S., the stock margin ratio is typically 2-to-1. This value is dramatically lower than TOS futures margin requirements or Etrade futures margins. For example, the 50 percent required equities margin is far greater than the standard 3 percent to 12 percent of a StoneX, TOS, or Etrade futures margin.
Although ratio analysis can be a bit intimidating, applying the margin to equity ratio and margin equity percentage concepts is fairly straightforward. Once you learn how to calculate the numbers, comparing such line items as “net liquidating value TD Ameritrade” to “net liquidating value Thinkorswim” becomes routine. In a snap, you’re able to answer questions such as:
Looking to get a better grasp on the nuances of financial risk management? For additional insights on successful trading strategies, download our free guide: 10 Rules for Technical Futures Trading.
This blog was originally published October 13, 2011 and has been updated for accuracy and comprehensiveness as of September 2024.