2. Margin, margin calls and forced liquidation

Derivatives 6: When it goes wrong

The previous module described the size of the possible loss. This one describes the mechanism by which that loss reaches your account, which is almost never the one imagined by whoever opens the position. Very few traders die because the market ends up where they feared. They die long before that, thrown out by an administrative procedure that is executed without negotiation and without waiting to see who was right.

Margin is not a good-faith deposit

Level 1 introduced margin on futures: the clearing house does not extend you credit, it demands a deposit and settles gains and losses daily. On a short options position the principle is the same, with one important difference: the margin required is not a fixed figure agreed when you open, but a calculation redone every day.

That calculation tries to answer a specific question: if a large adverse move happens tomorrow, how much would this position lose? The amount depends on the price of the underlying, on the distance to the strike and, very directly, on the level of volatility. None of those three variables is under your control, and all three move at once and in the same direction when the market turns ugly.

Why the requirement grows exactly when the market moves against you

Here is the heart of the problem, and it is three forces pushing simultaneously in the same direction:

• The position loses value, so your account equity falls. The numerator of your headroom shrinks.
• Volatility rises, so the margin model estimates larger potential losses and asks for more per contract. The denominator grows.
• The clearing house or the broker raise margin percentages for everybody when the market turns dangerous, with immediate effect and without your having done anything.

An example with figures. You have 50,000 in the account and ten short puts with margin of 3,000 per contract: 30,000 committed and 20,000 of headroom, which looks like a reasonable cushion. The index falls 7% and implied volatility doubles. Margin per contract goes to 9,000, so the total requirement rises to 90,000. At the same time, the position's unrealized loss has cut your equity to, say, 35,000. You need 90,000 and you have 35,000. You have closed nothing, you have not bought or sold a single extra contract, and you have just ended up 55,000 short.

The margin call and its clock

A margin call is the broker's notice demanding that you restore margin. It has three features worth internalizing before you need them:

• The deadline is short. It is usually counted in hours or in one session, not in days, and in extreme market conditions brokers shorten it further still.
• It admits only two answers. Put up fresh money or cut the position. There is no option to explain your thesis.
• The amount can go up again tomorrow. You top up today, the market keeps falling, volatility keeps rising and you are short of margin once more with less capital than before.

That third feature is what ruins anyone who decides to hold on by adding funds: they are not paying a bill, they are feeding a mechanism that feeds on itself.

Forced liquidation: the worst moment and the worst price

If you do not top up, the broker closes positions for you. It does not do so to punish you: it does so because the risk of your account going negative is its own. And it does so in the worst possible way from your point of view, for structural reasons rather than out of ill will.

It closes at market, without nursing the execution, at the exact moment when the spread has widened and the depth of the book has vanished. And you are not the only one: the margin call does not go only to you, it goes at the same time to everyone who held a similar position, so a mass of accounts are buying the same thing at the same time. That wave of forced buying pushes the price higher still, which triggers fresh margin calls in other accounts. The move stops being driven by opinions about the asset and starts being driven by the mechanics of margin.

The practical result is that your unrealized loss turns into a definitive one at the point of maximum panic. And there is a worse possibility: if the price gap is violent enough, the liquidation does not arrive in time and the account ends up owing money. In April 2020 the front-month US oil contract settled below zero, in the region of minus 37 dollars a barrel. Many retail traders who were long discovered that you can lose considerably more than you deposited, and some brokers took losses of tens of millions covering their clients' negative balances.

You can be right and be liquidated all the same

This is the point to take away from the module. Suppose your analysis was correct and that three weeks later the market returns to exactly where it was. It makes no difference. If you were liquidated at the low, you do not take part in the recovery: the position no longer exists. Solvency is checked every day; being right is only checked at the end. The line usually attributed to Keynes, that the market can stay irrational longer than you can stay solvent, is not a clever quip: it is an operational description of this mechanism.

From that comes the only reasonable defense, and it is one of sizing, not of analysis. Before opening a short position you have to work out how much margin it would require in a scenario of a sharp fall with volatility multiplied, not in today's scenario, and check that the amount fits in the account with room to spare. Someone committing 20% of their capital to initial margin survives the requirement tripling. Someone committing 80% does not.