Effects of Margin

The incredible effects of money management reflect its ability toachieve geometric growth. To a large degree, the low margin requirementsin the commodity and futures markets allow for substantialgeometric growth. Because margin is so low in these markets, it reallynever comes into play. For example, the margin on one corn contractis about $800. I have a corn system where the largest drawdownis about $2,000. According to this drawdown, a conservative FixedRatio approach would be to use a delta of $1,000. This means that thepotential losses of this situation exceed both the margin requirementand the money management increase requirement. Obviously, if youare only required to have $800 in the account to trade corn but havepotential losses of $2,000, you are going to fund the account withmore than $2,000. In fact, you must fund the account with the $2,000plus room for error plus room for the margin should the losses occur.Therefore, it would probably be smart to give this situation at least$4,000. This way, if the drawdown is hit, there is still enough in theaccount to continue trading. Further, contracts will not be increaseduntil there is an additional $1,000 in the account. Margin never evencomes into play in this situation.Currently, a corn contract is worth approximately $12,000. Supposethat the margin for corn is $6,000. What happens to the account balancerequired with the example in the previous paragraph? StartingAPPLYING THE FIXED RATIO METHOD TO STOCK TRADING 93with $4,000 is not even enough margin to trade that situation. Nowadd the drawdown plus room for error to the new margin requirementsand the proper account balance to trade one contract would beapproximately $9,000. According to this starting account balance andmoney management application, contracts would increase to 2 at$10,000. The problem here is that there is not enough margin to properlyincrease contracts. We need another $2,000 in the account tohave enough margin. This is the same way that margin comes intoplay when trading stocks. The easiest way around this is to makesure that there is enough money in the account to cover future increases.Instead of starting with $9,000, you would need to startwith $20,000 in the account. The following margin schedule showsthe proper margin to trade an additional contract in this example.The Fixed Ratio schedule shows a starting account balance of$20,000 with proper increase levels for each contract:Margin Fixed Ratio$ 6,000 1 contract $20,000 1 contract12,000 2 contracts 21,000 2 contracts18,000 3 contracts 23,000 3 contracts24,000 4 contracts 26,000 4 contracts30,000 5 contracts 30,000 5 contracts36,000 6 contracts 36,000 6 contractsThis beginning account level does not mean that you are risking anymore; it does not mean that the effect of money management is anydifferent. It is simply aligning the account balance with the ability toapply money management without ever having to deal with the marginrequirements.In the stock market, if you were to start out trading 100 lots andincrease by only 100 lots, you would prepare in a similar fashion. Thereason it is similar and not exact is that the margin rate is exactlyproportionate to the price of the stock. If the stock is $50 per share,you need at least $25 to trade it. If the price is $100 per share, youneed $50 to trade it. Suppose you are trading a $50 per share stock.With that $50 stock, your potential drawdown over the course of severaltrades is $10. Therefore, you would need approximately $25 formargin plus $10 for drawdown potential. To trade the stock with alittle room for error would require about $40. The first increase94 FIXED RATIO TRADINGwould come at $5 according to a conservative Fixed Ratio approach.The problem with this is that you are $5 shor’t in margin once the increaseoccurs. The proper starting account balance would be $75. Thefollowing margin schedule shows required margins and the FixedRatio schedule shows share increase levels:Margin Fixed Ratio$ 25 1 share $ 75 1 share50 2 shares 80 2 shares75 3 shares 90 3 shares100 4 shares 105 4 shares125 5 shares 125 5 shares150 6 shares 150 6 shares175 7 shares 180 7 sharesStarting with $75 in the account to trade one contract allows youto continue to trade without margin ever affecting the geometricgrowth from the application of the Fixed Ratio trading method.The math to calculate this is simply:Margin required/Delta=No. of units at which the deltas requiredand margin required to increase one additional contract occurs.Where margin = $25 and delta = $5:$25/$5 = 5You then apply the following calculation to determine the startingbalance:First is the total margin for 5 shares:5 shares x $25 = $125.Second is the total required to increase to 5 shares using a $5 delta:(No. of shares x No. of shares) - No. of shares / 2 x Delta= Total dollars required[($5 x $5) - $5]/ 2 x $5 = $50APPLYING THE FIXED RATIO METHOD TO STOCK TRADING 95You then subtract this amount from the required margin to trade 5shares and this becomes your starting account balance:$125-$50=$75A delta of $6 would be calculated as follows:$25 / $6 = 44x$25=$100($4 x $4 - $4) /$2 x $4 = $24$100 - $24 = $76 (the starting balance)Most traders do not start just trading one share of stock. If youbegin trading with 100 lots, you may increase the requirements accordingly.In addition, you do not have to begin increases by 100 lots,you may begin increases by 10 lots or 50 lots if you choose. Whateveryou choose, it is best to stick with that number as a unit. Using thismethod with 10 lot units, you would increase by 10 lots withoutchanging. To do this, you would need to calculate the beginning balanceaccording to the drawdown of trading 100 lots but the increaseaccording to a 10 lot drawdown. If the drawdown was $10 per share,you would have a total drawdown of $1,000 according to the beginningbalance but would use a delta of $50 to increase units of 10 lots.Therefore, the following schedules would apply:Margin$2,500 100 shares2,750 110 shares3,000 120 shares3,250 130 shares3,500 140 shares3,750 150 shares4,000 160 sharesFixed Ratio$3,000 100 shares3,050 110 shares3,150 120 shares3,300 130 shares3,500 140 shares3,750 150 shares4,050 160 sharesAs you can see, you only have to start out with an extra $500 in theaccount to nullify margin problems while using the same moneymanagement concepts as with the commodity and futures markets.You will want to make room for the $1,000 drawdown at the beginningbut that does not affect the application of money managementsince profits are required to increase.96 FIXED RATIO TRADING APPLYING THE FIXED RATIO METHOD TO STOCK TRADING 97Trading a Basket of StocksTrading a basket of stocks follows a similar pattern. For example, ifyou were trading a basket of 10 stocks and all 10 average out to beabout $50 per stock, you would configure the margin requirementsand follow the same process. The most conservative way to configurethis would be to assume a position in all 10 stocks at the same time. Ionce applied a system to over 250 different stocks at one time. However,there were usually only about 5 open positions at any given timeand never more than 8. As a result, I only needed to calculate marginfor a maximum of 10 stocks with a higher average price. Likewise, ifit is virtually impossible to be in all 10 stocks at the same time, youmay only need to calculate margin for 5 or 6 of them. Nonetheless, wewill use all 10 just to be on the ultraconservative side:5 x $25 (margin for average 1 share) = $125Trading 100 lots of each would require a margin of $12,500.If the final drawdown was at $15, you would use a delta of $75 toincrease from 100 lots to 110 lots. The following schedule would apply:Margin$12,500 100 shares13,750 110 shares15,000 120 shares16,250 130 shares17,500 140 shares18,750 150 shares20,000 160 sharesFixed Ratio$18,950 100 shares19,025 110 shares19,100 120 shares19,250 130 shares19,450 140 shares19,700 150 shares20,000 160 sharesThe mechanics of the application do not change. You simply mustaccount for the higher margin requirements. Once that is done,everything remains relatively the same.How to Handle the Different Stock Pricessame argument I use in the commodity markets. Corn is not the S&Pand sugar is not cocoa. They are different. Different is what gives usdiversity. If you want to equalize everything, why diversify? If youtake everything into account, there is no reason to equalize theprices of the stocks. If you are trading the system on these stocks,the entry and exit rules should be the areas to cover the differencesin the volatility. A $10 stock probably has a much smaller chance ofsuffering the same size drawdown as a $100 stock. If the $10 stockonly has a drawdown of $2 and the $100 stock has a drawdown of$15, the two chronologically combined may have a $16 drawdown andcannot have more than a $17 drawdown (provided that the $2 and $15drawdowns are not individually exceeded). In this situation, you havetaken both into account.This subject is covered extensively in Chapters 8, 9, and 10. Remember,money management is a numbers game. It is not affected bythe markets or types of markets, or by the systems and methods thatare applied to those markets. Keep this in mind as you read the restof the book. This fact will be restated many times in the followingchapters. The bottom line is that these principles can be appliedacross the board where markets are leveraged.