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Margin-to-Equity Ratio in stock market

by: Steve on Date: Fri, 20 Aug 2010 Time: 3:44 AM

As discussed in detail in Section Two, one of the keys to long-term success in stock market is to develop a portfolio which is “right” for the amount of capital that you have in your account.
If you trade “too small” you forego the opportunity to make money that you could make in stock market.

If you trade “too big” you run the risk of experiencing sharp and occasionally painful drawdowns in your account equity, which may cause you to stop trading prematurely in stock market. This not only eliminates the opportunity to make money it also eliminates the opportunity to recoup your losses in stock market. If you trade “way too big” for your account size you run the risk of “tapping out.”While the discussion in Section Two was fairly detailed, there is a simple rule-of-thumb measure that can tell you how heavy you have your foot on the gas. This measure is referred to as the margin-to-equity ratio.

To calculate this ratio simply adds up the initial margin requirements for all of the positions in your portfolio. Then divide this total by the equity in your trading account to arrive at your margin-to equity ratio. Let’s look at a simple example.
Trader A has a $30,000 trading account and at any point in time may have positions in T-Bonds, Soybeans, Crude Oil and Japanese Yen. Let’s also assume that the initial margin requirements for each market are as follows:

T-Bonds $2700
Soybeans $ 750
Crude Oil $1400
Japanese Yen $2650

If we add up these initial margin requirements we get a total of $7,500. In other words, if this trader were long or short one contract of each of these markets at the same time, his
brokerage firm would require him to hold a bare minimum of $7,500 in his account. If we divide $7,500 by the $30,000 that he actually has in his account, we get a ratio of 25%. So this trader’s margin-to-equity ratio is 25%.

This value can and will change over time. Clearly, as the equity in his account rises or falls this value will change. Also, margin requirements that are set by the exchanges can and do change from time to time based on the fluctuations of individual markets. Finally, as the number of positions you hold rises, your margin-to-equity ratio rises, and as the number of positions you hold declines, your margin-to-equity ratio declines. The obvious question is “what is the right margin-to-equity ratio to maintain?” If your only goal is to maximize your profitability there seemingly is no reason to limit your margin-to-equity ratio. However, the other side of the coin is risk exposure. While the margin-to-equity ratio does not measure your actual dollar risk, it does give you a quick and easy way to get a handle on the relative level of exposure you have in the market place at any given point in time. In other words, if your margin-to-equity ratio is 10%, clearly you have less exposure than if it were 30%. The ultimate goal is to maximize your profitability while minimizing your exposure to risk. If Investor A and Investor B both make 20% a year, but Investor A uses an average margin-to-equity ratio of 10% while Investor B uses an average margin-to-equity ratio of 30%, clearly Investor A is the more efficient trader as well as the one less likely to run into trouble along the way.

As far as what is the “right” margin-to-equity ratio, for this there is no absolute right or wrong answer. The general rule-of-thumb regarding a prudent maximum margin-to equity ratio is 30%. In other words, most traders would be well advised to maintain a margin-to-equity ratio below 30%. Trading with a margin-to-equity ratio greater than 30% should be considered an “aggressive” approach to trading futures.

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