UNDERSTANDING MARGIN CALLS

UNDERSTANDING MARGIN CALLS:

What Are They and How Do They Work?

Written by: Katie Tangen, Marketing Education Specialist

It’s no secret that a vast part of grain marketing strategy is psychological. However, discipline, patience, and sheer mental fortitude are all important qualities in executing a risk management plan. That can be especially tough when the market makes major swings in direction like we’ve seen in the past 18 months. Conversations in the winter of 2020 concentrated on how to make sales so that producers could have some form of profitability. The stress of not making money was real, but the downside risk was smaller. Today, the stress is still real but focused more on increased number of dollars on the line due to higher input costs. This stress can be particularly pointed if you’ve chosen to hedge your grain using futures contracts in your own account. In this case, each day the markets go up raises the unpleasant specter of a margin call.

First off, let’s discuss what margin is. If a producer chooses to sell their grain using futures contracts in an account that they themselves are managing, they have, in essence, agreed to deliver a certain amount of grain at a specific futures price over a designated time frame. For example, a producer might have sold 5,000 bushels (one contract) of corn at $5.00 for December delivery. At the time this was booked, $5.00 futures looked good. Fast forward and say December futures are trading at $5.50. A producer might say in their head, I don’t want to sell grain at $5.00 anymore, I want $5.50. To avoid this, the clearing house facilitating the trade requires that a certain amount of good faith money be held in an account. Every time the market moves against you, the move is “charged” against your account and you must deposit money to maintain a certain balance. This money is margin. When you need more in the account, the broker will call and tell you the amount; hence, a margin call. These funds are in a segregated customer account with your name on them. If the market goes back in your favor, you get credit back. Any cash above the required margin amount is available for withdrawal. Upon delivery of the physical crop to the elevator, you lift the hedge and the higher futures price on the cash sale offsets the loss in the margin account.

So, what’s the problem? In fast rising markets, producers can experience these margin calls on a daily, or near daily, basis. While the sale was hopefully done at a profitable level, the act of writing out a check, sending a wire, or ACH every day is taxing. Psychologically, it acts as a reminder that you could have done something better. It’s one reason producers need to consider whether they are comfortable with selling futures in a trading account and why futures trading isn’t for everyone.

The reality is, even if you’d sold a futures fix or hedge to arrive (same contract, just different terms), you’d still feel behind. You might not have the daily reminders in front of you, but in the end, you still have a $5.00 futures sale. An elevator is likely going to charge you a fee of some sort to execute the futures fixed contract, and that money - at least partially - goes to paying interest on the elevator’s own hedging line of credit. Times like this are when producers can feel like they’ve made a huge mistake in selling ahead.

The truth is marketing is hard no matter what. Discipline is crucial—especially when the momentum of the market is pushing you to think each day brings higher prices. Here are a few tips:

1. Find the level you feel comfortable making a sale at and stick to it. This price should take into account current market conditions and your costs. The chances of selling 100% of your crop at the high tick is slim to none. Scaling into sales is fine. In fact, while we’ve always encouraged marketing plans, producers need to keep reviewing and altering them as necessary. That doesn’t mean constantly moving everything higher; it just means re-evaluating major changes while attempting to leave emotion out of it.

2. If you haven’t already done so, decide now how much of your production you want to sell on futures ahead of time and at what percentage of your expected production. Do you want to use options? On what percent? It’s a good idea to use a few different methods of selling.

3. Whatever you decide, make a plan and stick to it. That can be difficult now. Here’s the thing: if you always sell ahead, keep selling ahead. Yes, you feel behind now, but if you keep doing it, you’ll catch up on the backside of the rally. If you always sell after harvest, fine. You’re reaping the benefits now. It’s a good time to consider looking at selling more ahead, but don’t switch without a plan ahead of time.

4. On a related point, if you are hedging in a futures account, stick with it. The risk of paying in margin, getting scared and jumping out at a loss is very real. There’s also absolutely no guarantee that the market will keep going up enough to offset that loss, in which case you’ve made a bad situation worse.

The market for 2022 so far has great opportunity, and something not many would have counted on even two years ago. Now is the time to look at building for the future but not without a plan and strong risk mitigation strategies in place. If you have any questions on this, please contact Rob Fronning, Jeff Beaudry or me, or get in touch with your loan officer or insurance specialist. I wish you a safe and productive spring!