Margin investing - how risky is it really?

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Yesterdaysnews
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Margin investing - how risky is it really?

Post by Yesterdaysnews » Wed Aug 03, 2016 3:43 pm

Just for grins, I put into the Interactive Broker margin calculator what I would pay in interest if I had a $2 million brokerage portfolio -- it spit out approximately 1%.

How risky would it really be to take out a 20 or max 25% margin position at 1% (so borrow let's say 400k or 500k against the $2 million in equity) and invest in dividend aristocrat stocks or similar ETFs?

You would make a spread on the interest cost just from the dividend not even considering potential stock value appreciation over time.

It would require a mammoth crash to trigger a margin call as well, since leverage ratio is quite low.

One could always end the strategy if there is a spike in interest rates.

While I am unlikely to ever actually institute such a strategy as I am not near $2M in my brokerage account, I am curious why this would be a bad idea for those who might have such an account balance?

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Re: Margin investing - how risky is it really?

Post by michaeljc70 » Wed Aug 03, 2016 4:39 pm

Your 2% or 3% in annual dividends could be wiped out by stock losses in one day.
One could always end the strategy if there is a spike in interest rates.
What if this spike occurs when the market is in a downturn?

I suppose in theory, if you did this and stuck with it for decades, you might come out ahead, but it isn't worth the risk.

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Re: Margin investing - how risky is it really?

Post by livesoft » Wed Aug 03, 2016 4:45 pm

I'm laughing about the dividend because you don't get the dividend, but have to pay them to the people you borrowed the stock(s) from. That's another cost above the interest for borrowing.

But certainly borrowing to buy a broad market index fund is less risky than borrowing to buy an individual stock.
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Re: Margin investing - how risky is it really?

Post by triceratop » Wed Aug 03, 2016 4:55 pm

Have you read market timer's thread? What about that didn't convince you it can be risky?
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Re: Margin investing - how risky is it really?

Post by Yesterdaysnews » Wed Aug 03, 2016 5:05 pm

livesoft wrote:I'm laughing about the dividend because you don't get the dividend, but have to pay them to the people you borrowed the stock(s) from. That's another cost above the interest for borrowing.
Can you explain this further? I thought you borrow money to buy more stock than you normally could.

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Re: Margin investing - how risky is it really?

Post by Yesterdaysnews » Wed Aug 03, 2016 5:10 pm

triceratop wrote:Have you read market timer's thread? What about that didn't convince you it can be risky?
Certainly, it is risky. However, most people get approved for 50% initial margin which means you can double your purchasing power. I can see how it would not be that difficult to go broke with 1:1 equity to debt ratio. I am curious about something like 4:1 equity to debt ratio however, meaning let's say you can buy $2M in stock with cash, but use margin to bump your buying power to $2.5M. While the benefits of the margin loan are less, at 1% interest rate it seems like it could still be worthwhile.

Really just an academic / mental exercise.

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Re: Margin investing - how risky is it really?

Post by Day9 » Wed Aug 03, 2016 5:10 pm

If you have the need, willingness, and ability to take risk beyond a very high stock allocation it is better to tilt more strongly to other risk factors like small and value, and increase allocation to international and emerging markets which have lower valuations and higher expected returns. But even this should be cautioned against. It is likely that you do not have either the need to take so much risk, the willingness, the ability, or a combination of these.

It has been argued in this forum, particularly on this thread that a modestly leveraged portfolio that is diversified across asset classes can have higher expected return with lower risk than an unlevered 100% stock portfolio due to diversification benefits. But this is debatable, to say the least.

Beyond this, one of our core principles is to Invest With Simplicity and using leverage greatly increases complexity. There are lots of tax considerations depending on the medium of leverage you employ (margin, options, futures), you have to not only rebalance among your asset allocation but consider a plan for rebalancing to your target leverage ratio.
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Re: Margin investing - how risky is it really?

Post by Valuethinker » Thu Aug 04, 2016 11:40 am

Yesterdaysnews wrote:Just for grins, I put into the Interactive Broker margin calculator what I would pay in interest if I had a $2 million brokerage portfolio -- it spit out approximately 1%.

How risky would it really be to take out a 20 or max 25% margin position at 1% (so borrow let's say 400k or 500k against the $2 million in equity) and invest in dividend aristocrat stocks or similar ETFs?

You would make a spread on the interest cost just from the dividend not even considering potential stock value appreciation over time.

It would require a mammoth crash to trigger a margin call as well, since leverage ratio is quite low.

One could always end the strategy if there is a spike in interest rates.

While I am unlikely to ever actually institute such a strategy as I am not near $2M in my brokerage account, I am curious why this would be a bad idea for those who might have such an account balance?
If the market drops 25% say the portfolio drops to $1.5m and the margin is called?

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Re: Margin investing - how risky is it really?

Post by livesoft » Thu Aug 04, 2016 11:41 am

Yesterdaysnews wrote:
livesoft wrote:I'm laughing about the dividend because you don't get the dividend, but have to pay them to the people you borrowed the stock(s) from. That's another cost above the interest for borrowing.
Can you explain this further? I thought you borrow money to buy more stock than you normally could.
I was probably mistaken. I was confusing buying on margin with short-selling.
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Re: Margin investing - how risky is it really?

Post by rmelvey » Thu Aug 04, 2016 11:44 am

Another thing to consider is that if you open a margin account your shares can be lent to other investor's and your dividends will no longer be qualified...

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Re: Margin investing - how risky is it really?

Post by technovelist » Fri Aug 05, 2016 10:09 am

rmelvey wrote:Another thing to consider is that if you open a margin account your shares can be lent to other investor's and your dividends will no longer be qualified...
Are you saying that merely having a margin account (without borrowing on it) means that dividends paid in that account are not qualified dividends? I've never heard of that rule before. Do you have a reference for this?
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Re: Margin investing - how risky is it really?

Post by rmelvey » Fri Aug 05, 2016 10:21 am

technovelist wrote:
rmelvey wrote:Another thing to consider is that if you open a margin account your shares can be lent to other investor's and your dividends will no longer be qualified...
Are you saying that merely having a margin account (without borrowing on it) means that dividends paid in that account are not qualified dividends? I've never heard of that rule before. Do you have a reference for this?
When you open a margin account you almost always are required to put your shares up to be available for lending. If they end up getting lent out (typically to a short seller), then the person who borrowed the shares pays you the dividends you would have received, but these payments are not qualified. This would not affect all of your dividends, only the shares that got lent out. If you held stock in companies or ETFs that were very popular with short sellers, then it could affect a large portion of your portfolio.

https://www.fidelity.com/taxes/tax-topi ... e-payments

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Re: Margin investing - how risky is it really?

Post by Daryl » Fri Aug 05, 2016 4:51 pm

Instead of using InteractiveBrokers margin rates, you should look into equity index futures (including the S&P emini /ES). The implied interest rate is very low and the leverage available is incredible. What could go wrong?

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Re: Margin investing - how risky is it really?

Post by technovelist » Fri Aug 05, 2016 5:10 pm

rmelvey wrote:
technovelist wrote:
rmelvey wrote:Another thing to consider is that if you open a margin account your shares can be lent to other investor's and your dividends will no longer be qualified...
Are you saying that merely having a margin account (without borrowing on it) means that dividends paid in that account are not qualified dividends? I've never heard of that rule before. Do you have a reference for this?
When you open a margin account you almost always are required to put your shares up to be available for lending. If they end up getting lent out (typically to a short seller), then the person who borrowed the shares pays you the dividends you would have received, but these payments are not qualified. This would not affect all of your dividends, only the shares that got lent out. If you held stock in companies or ETFs that were very popular with short sellers, then it could affect a large portion of your portfolio.

https://www.fidelity.com/taxes/tax-topi ... e-payments
Ok, that's a wrinkle I didn't know about.

I don't think any of my shares have ever been lent out, and the only ones I have that pay any dividends pay tiny dividends that wouldn't affect my taxes significantly anyway. And apparently Fidelity makes up the difference so it wouldn't matter much in any case, but it's good to know about anyway. Thanks.
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Re: Margin investing - how risky is it really?

Post by JoMoney » Fri Aug 05, 2016 5:50 pm

There's a lot that can go wrong. Interest rates can rise at inopportune times for selling, dividends are not a promised bond coupon and can change at any time. Someone carrying a low amount of debt/leverage likely won't have the extreme troubles of someone leveraged to the hilt, and there are types of leverage that don't run the risk of a 'margin call', but there are still lots of issues you can run into. A small amount of leverage might be beneficial, but where do you draw the line with how much leverage is too much? A lot of people are already leveraged up on balance if accounting for mortgages, student loans, credit cards, etc..
Quite a few on here don't like the idea of a 100% stock portfolio, I can't imagine what the appeal would be to push it a little beyond that.

Edward Thorpe wrote a paper where doing some calculations using the Kelly criterion, and a model based on historical stock market risk/returns (he also normalized the distribution removing some tails, which might make the model unrealistic) he came up with a ratio to maximize returns of having the portfolio levered to about 117% (using Kelly to avoid risk of ruin). Even in the paper though, he points out this might not be something anyone should really do acknowledging the limitations and real risks that the model just doesn't account for.
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Re: Margin investing - how risky is it really?

Post by Jack FFR1846 » Fri Aug 05, 2016 5:54 pm

I had a coworker who was heavily leveraged with a margin account. Then October of 87 happened and he did everything he could to avoid his broker's phone calls. I think he eventually sold a rental property to cover his losses.
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Re: Margin investing - how risky is it really?

Post by randomguy » Fri Aug 05, 2016 5:55 pm

triceratop wrote:Have you read market timer's thread? What about that didn't convince you it can be risky?
That is a lot like saying investing in stocks is risky because Enron went to zero so you shouldn't be invesing in a total market etf. 5x+ leverage and buying stocks on your credit card might be suicidal (I sure think so.) but that doesn't mean say 25% leverage would be also be. Obviously the gains are also capped (i.e. you make an extra 25% not 400%+).

What are the risk with lower levels of margin?
a) 50%+ market drops cause margin calls. I could live with this

b) stocks under perform the interest rates (i.e. I make -5% while paying 1%) and you end up with more loses. Over say 10 years I could live with this risk.

c) Odds of interest rates rising out side of my comfort zone. I am comfortable saying my investments will return say 5% nominal over the next 10 years giving me a nice profit if I am paying 1%. If I am paying like 6% interest, my comfort level that stocks will return that much drops a lot. This one is hard to evaluate. Some of it will come to in figuring out how hard it is to unwind your position (say the markets are having one of their yearly 10% dips) and how long it will take (i.e. I have to imagine it would take years for the rates to rise that high. But crap happens).

Throw in the deduction of margin interest (I have enough investment income) and I think I could make a good arguement for doing it. That extra 1-2% return I would hope to get doesn't sound like much but over 30 years it could result in having a 1/3 more money. Of course I also wouldn't expect this situation of low, low margin rates to last forever. But I have also looked at the complexity and said it just isn't worth it right now.

And finally you need to be insanely discplined. If you are making nice money at 25% leverage, you might be tempted to keep upping it. And then you get slaughtered.

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Re: Margin investing - how risky is it really?

Post by selters » Fri Aug 05, 2016 6:02 pm

rmelvey wrote:Another thing to consider is that if you open a margin account your shares can be lent to other investor's and your dividends will no longer be qualified...
Your ETFs and even traditional mutual fund shares, too?

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Re: Margin investing - how risky is it really?

Post by JoMoney » Fri Aug 05, 2016 8:28 pm

JoMoney wrote:...Edward Thorpe wrote a paper where doing some calculations using the Kelly criterion, and a model based on historical stock market risk/returns (he also normalized the distribution removing some tails, which might make the model unrealistic) he came up with a ratio to maximize returns of having the portfolio levered to about 117% (using Kelly to avoid risk of ruin). Even in the paper though, he points out this might not be something anyone should really do acknowledging the limitations and real risks that the model just doesn't account for.
Incidentally, after going back and looking at this paper, I decided to play around with PortfolioViusalizer.
Using a portfolio rebalanced annually between a S&P500 2x Daily ETF and a regular S&P 500 ETF. Anything below a ratio of 17/83 managed to eek out a slightly better return than either the 100% S&P 500 or the 2x S&P 500 daily (which is only just barely recovering from the crushing crisis period).
Rebalancing more frequently (like monthly) killed any advantage on the levered portfolio, and the 2x Daily ETF had an expense ratio over 1% (which likely isn't including the fees incurred by the fund actually trading and borrowing).
I think it's highly likely a small amount of leverage, if held cheaply, and not traded/rebalanced too frequently could boost returns a little bit. But I still wouldn't do it. The potential increases are quite marginal, there's additional risks and complexity that just isn't necessary. Then there's the behavioral issues that are hard to gauge.
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Leverage can be a slippery slope that's sucked in many many investors with it's allure of larger/quicker gains with just a little bit more. With some things, even if a little bit wouldn't hurt you it's best to just avoid it completely than trying to decide how much is too much.
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Re: Margin investing - how risky is it really?

Post by GoldenFinch » Fri Aug 05, 2016 8:41 pm

Very risky. Don't use margin unless you want to go broke. Many have travelled this route. Don't follow.

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Re: Margin investing - how risky is it really?

Post by whodidntante » Fri Aug 05, 2016 10:13 pm

If you borrow 25% of your portfolio on margin to reinvest, the main risk would not be a margin call that ruins you, but behavioral mistakes. A lot of people can't even behave in their own best interest with a 100% stock portfolio. Fewer still with a 125% stock portfolio and a million dollar loan outstanding.

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Re: Margin investing - how risky is it really?

Post by jcar » Fri Aug 05, 2016 10:24 pm

If you're committed to using margin why not start out using a leveraged closed end fund? Might be a way to ease into this area.

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Re: Margin investing - how risky is it really?

Post by Watty » Fri Aug 05, 2016 10:40 pm

I don't know how you would correctly calculate the percentages but using margin would really mess up your asset allocation especially if you count the margin loan as a negative bond.

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Re: Margin investing - how risky is it really?

Post by Daryl » Sat Aug 06, 2016 4:26 am

Watty wrote:I don't know how you would correctly calculate the percentages but using margin would really mess up your asset allocation especially if you count the margin loan as a negative bond.
I hold derivatives in my retirement account and calculate my asset allocation using notional values (for futures contracts). I very much doubt that most people adjust their asset allocation for their mortgage (negative bond).

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Re: Margin investing - how risky is it really?

Post by rmelvey » Sat Aug 06, 2016 7:50 am

Daryl wrote:
Watty wrote:I don't know how you would correctly calculate the percentages but using margin would really mess up your asset allocation especially if you count the margin loan as a negative bond.
I hold derivatives in my retirement account and calculate my asset allocation using notional values (for futures contracts). I very much doubt that most people adjust their asset allocation for their mortgage (negative bond).
How much work is it to maintain the futures position? Do you roll it over every couple of months? Do you do this with equities or also bonds?

I've always been interested in futures because of the low cost leverage, but it seems the opposite of hands off.

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Re: Margin investing - how risky is it really?

Post by randomguy » Sat Aug 06, 2016 8:24 am

whodidntante wrote:If you borrow 25% of your portfolio on margin to reinvest, the main risk would not be a margin call that ruins you, but behavioral mistakes. A lot of people can't even behave in their own best interest with a 100% stock portfolio. Fewer still with a 125% stock portfolio and a million dollar loan outstanding.
It might be more like holding a
75% stock
40% bond portfolio

Yes the volatility will be more than the unleveraged 60/40 and the returns will only be slightly higher. And yes behavioral mistakes are always an issue. You need to know who you are. If you made it through 2000-2, 2008-9 without losing sleep, you will be fine. If you were panicing and talking about plan b, it might not be a great idea

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Re: Margin investing - how risky is it really?

Post by jimbojones » Sat Aug 06, 2016 10:50 am

I'm curious: where could you actually get margin at 1%? TD Ameritrade's margin rate is 6.5% for $1M+.

https://www.tdameritrade.com/pricing/ma ... rates.page

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Re: Margin investing - how risky is it really?

Post by Rob Bertram » Sat Aug 06, 2016 10:54 am

Let's dispel some urban legends around leverage. Managing a leveraged portfolio is no more complex than managing a 3-fund portfolio. And while there are anecdotal stories about people losing everything, small amounts of leverage will not make you go bankrupt.

As far as how to model a leveraged portfolio, William Sharpe did a lot of work creating the Capital Asset Pricing Model (CAPM). So we don't need to reinvent the wheel. Instead of treating a margin loan as a bond, CAPM treats it like cash. It is fairly simple: Start by plotting your unleveraged portfolio on the efficient frontier. Next, draw a line from the y-axis corresponding to the risk-free (cash) rate through your portfolio. That is called the capital asset line. Points on the line to the left of your portfolio are those that have reduced risk due to carrying some amount of cash. Points to the right represent increased risk due to carrying margin.

Image

There is tons more information in the thread that Day9 linked:
Day9 wrote:It has been argued in this forum, particularly on this thread that a modestly leveraged portfolio that is diversified across asset classes can have higher expected return with lower risk than an unlevered 100% stock portfolio due to diversification benefits. But this is debatable, to say the least.

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Re: Margin investing - how risky is it really?

Post by randomguy » Sat Aug 06, 2016 11:10 am

jimbojones wrote:I'm curious: where could you actually get margin at 1%? TD Ameritrade's margin rate is 6.5% for $1M+.

https://www.tdameritrade.com/pricing/ma ... rates.page
Interactive brokers (https://www.interactivebrokers.com/en/index.php?f=1595) is generally the cheapest by a good amount.

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Re: Margin investing - how risky is it really?

Post by Rob Bertram » Sat Aug 06, 2016 11:14 am

jimbojones wrote:I'm curious: where could you actually get margin at 1%? TD Ameritrade's margin rate is 6.5% for $1M+.

https://www.tdameritrade.com/pricing/ma ... rates.page
Interactive Brokers offers a progressively lower margin rate the more you borrow. If I remember correctly, it starts off at the fed funds rate (currently around 0.375%) + 1.5% for the first $100k, then eventually drops down to FFR + 0.5% once you get up to $3 million.

The implied financing on e-mini S&P500 futures is around 0.5%, and the financing rate on treasury futures is the LIBOR 3-month rate which is around 0.6%.

edit: randomguy beat me to it.

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Re: Margin investing - how risky is it really?

Post by Rob Bertram » Sat Aug 06, 2016 11:20 am

rmelvey wrote:How much work is it to maintain the futures position? Do you roll it over every couple of months? Do you do this with equities or also bonds?

I've always been interested in futures because of the low cost leverage, but it seems the opposite of hands off.
You do have to roll futures every quarter. It takes maybe 2 minutes each time. If you hold both stock and bond futures, they roll on different dates. So you'll have to log into your brokerage account at least 8 times a year.

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Re: Margin investing - how risky is it really?

Post by Rob Bertram » Sat Aug 06, 2016 11:46 am

randomguy wrote:
whodidntante wrote:If you borrow 25% of your portfolio on margin to reinvest, the main risk would not be a margin call that ruins you, but behavioral mistakes. A lot of people can't even behave in their own best interest with a 100% stock portfolio. Fewer still with a 125% stock portfolio and a million dollar loan outstanding.
It might be more like holding a
75% stock
40% bond portfolio

Yes the volatility will be more than the unleveraged 60/40 and the returns will only be slightly higher. And yes behavioral mistakes are always an issue. You need to know who you are. If you made it through 2000-2, 2008-9 without losing sleep, you will be fine. If you were panicing and talking about plan b, it might not be a great idea
There is significantly more discussion in this thread, but I will try to summarize. We as humans cannot tell the difference between abstract risk constructs like volatility. For example, showing me a chart with 15% standard deviation looks very similar to a chart with 20% standard deviation. I couldn't tell you if I would panic in one as opposed to the other. On the other hand, something like drawdown is very understandable from a human perspective. We often use this to construct our asset allocations. For example, we quote Larry Swedroe for describing the following situations in the wiki:
  • A 40% stock / 60% bond portfolio has historically seen a 15% drawdown during a bear market,
  • A 60% stock / 40% bond portfolio has historically seen a 25% drawdown during a bear market, and
  • A 100% stock portfolio has historically seen a 50% drawdown during a bear market.
So if you leverage the 60/40 portfolio by 1.25x, you would expect a 25% * 1.25 = 31.25% drawdown which is slightly more than the 70/30 portfolio.

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Re: Margin investing - how risky is it really?

Post by Daryl » Sat Aug 06, 2016 12:56 pm

Rob Bertram wrote:
rmelvey wrote:How much work is it to maintain the futures position? Do you roll it over every couple of months? Do you do this with equities or also bonds?

I've always been interested in futures because of the low cost leverage, but it seems the opposite of hands off.
You do have to roll futures every quarter. It takes maybe 2 minutes each time. If you hold both stock and bond futures, they roll on different dates. So you'll have to log into your brokerage account at least 8 times a year.
I'm maintaining a small equity position using /ES, rolling quarterly. It is a little more involved, only in that I need to monitor the cash in my futures account. If the value of the S&P 500 drops enough, I could be forced to liquidate something / add additional funding from an outside source. A standard Boglehead RBD wouldn't be enough to trigger a margin call, but several of those in a row would.

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Re: Margin investing - how risky is it really?

Post by Swelfie » Sat Aug 06, 2016 1:49 pm

Daryl wrote:I'm maintaining a small equity position using /ES, rolling quarterly. It is a little more involved, only in that I need to monitor the cash in my futures account. If the value of the S&P 500 drops enough, I could be forced to liquidate something / add additional funding from an outside source. A standard Boglehead RBD wouldn't be enough to trigger a margin call, but several of those in a row would.
Also, people should understand that you can get way more leverage than you probably want in a future. You are probably going to have a whole lot of cash lying around, so the market would have to tank drastically for me to need to liquidate something. In that respect, I'm not constantly monitoring. If the market starts to tank that badly in a single quarter, I'll hear about it.

I do have alerts set up because my "cash" outside of a buffer (I use maintenance margin plus initial margin as my buffer to avoid excess trades) is actually shares of SHV. So I might have to liquidate some of those in a moderate turn down, but I don't count those as investments, they are just cash earning a slightly higher interest rate waiting for the day they need to cover margin.

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