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When analyzing fundamental valuation ratios for micro cap stocks, it is important not to let any single factor summarily eliminate a stock from consideration. Because of the relatively dynamic financial nature of micro cap companies, there are reasons, at times, to discount some factors while putting more weight on other factors when reviewing the financial ratios of a company. For example, there are many rapidly growing small companies that generate very little free cash flow. Conversely, there are small companies that generate very modest earnings growth but generate significant levels of free cash flow from operations. Simple screening techniques could eliminate either of the companies from consideration; however, a little more effort within the analysis can yield potentially great stocks.
As is the case with financial ratios, certain measures will be more or less applicable, depending on the sector within which a company operates. It is often the best strategy to use ratios that reflect a company’s valuation relative to its peers rather than relative to the market. In addition, it is important to study the accounting practices of the company and its peers to determine whether any adjustments are necessary for different accounting policies and procedures. For example, manufacturing companies tend to lend themselves better to cash flow and EBITDA (earnings before interest, taxes, depreciation, and amortization) analysis, whereas fast-growing service companies tend to better lend themselves to price-to-sales ratio analysis or earnings-per-share growth analysis.

As briefly noted in the previous posts, when a trader takes a long or short position in a futures, he must first deposit sufficient funds in a margin account. This amount of money is traditionally called the margin, a term derived from the stock market practice in which an investor borrows a portion of the money required to purchase a certain amount of stock. Margin in the stock market is quite different from margin in the futures market. In the stock market, “margin” means that a loan is made. The loan enables the investor to reduce the amount of his own money required to purchase the securities, thereby generating leverage or gearing, as it is sometimes known. If the stock goes up, the percentage gain to the investor is amplified. If the stock goes down, however, the percentage loss is also amplified. The borrowed money must eventually be repaid with interest. The margin percentage equals the market value of the stock minus the market value of the debt divided by the market value of the stock-in other words, the investor’s own equity as a percentage of the value of the stock. For example, in the United States, regulations permit an investor to borrow up to 50 percent of the initial value of the stock. This percentage is called the initial margin requirement. On any day thereafter, the equity or percentage ownership in the account, measured as the market value of the securities minus the amount borrowed, can be less than 50 percent but must be at least a percentage known as the maintenance margin requirement. A typical maintenance margin requirement is 25 to 30 percent. In the futures market, by contrast, the word margin is commonly used to describe the amount of money that must be put into an account by a party opening up a futures position, but the term is misleading. When a transaction is initiated, a futures trader puts up a certain amount of money to meet the initial margin requirement; however, the remaining money is not borrowed. The amount of money deposited is more like a down payment for the commitment to purchase the underlying at a later date. Alternatively, one can view this deposit as a form of good faith money, collateral, or a performance bond: The money helps ensure that the party fulfills his or her obligation.’ Moreover, both the buyer and the seller of a futures contract must deposit margin.
In securities markets, margin requirements are normally set by federal regulators. In the United States, maintenance margin requirements are set by the securities exchanges and the NASD. In futures markets, margin requirements are set by the clearinghouses. In further contrast to margin practices in securities markets, futures margins are traditionally expressed in dollar terms and not as a percentage of the futures price. For ease of comparison, however, we often speak of the futures margin in terms of its relationship to the futures price. In futures markets, the initial margin requirement is typically much lower than the initial margin requirement in the stock market. In fact, futures margins are usually less than 10 percent of the futures price.’ Futures clearinghouses set their margin requirements by studying historical price movements. They then establish minimum margin levels by taking into account normal price movements and the fact that accounts are marked to market daily. The clearinghouses thus collect and disburse margin money every day. Moreover, they are permitted to do so more often than daily, and on some occasions they have used that privilege. By carefully setting margin requirements and collecting margin money every day, clearinghouses are able to control the risk of default.
In spite of the differences in margin practices for futures and securities markets, the effect of leverage is similar for both. By putting up a small amount of money, the trader’s gains and losses are magnified. Given the tremendously low margin requirements of futures markets, however, the magnitude of the leverage effect is much greater in futures markets. We shall see how this works as we examine the process of the daily settlement. As previously noted, each day the clearinghouse conducts an activity known as the daily settlement, also called marking to market. This practice results in the conversion of gains and losses on paper into actual gains and losses. As margin account balances change, holders of futures positions must maintain balances above a level called the maintenance margin requirement. The maintenance margin requirement is lower than the initial margin requirement. On any day in which the amount of money in the margin account at the end of the day falls below the maintenance margin requirement, the trader must deposit sufficient funds to bring the balance back up to the initial margin requirement. Alternatively, the trader can simply close out the position but is responsible for any further losses incurred if the price changes before a closing transaction can be made.
To provide a fair mark-to-market process, the clearinghouse must designate the official price for determining daily gains and losses. This price is called the settlement price and represents an average of the final few trades of the day. It would appear that the closing price of the day would serve as the settlement price, but the closing price is a single value that can potentially be biased high or low or perhaps even manipulated by an unscrupulous trader. Hence, the clearinghouse takes an average of all trades during the closing period (as defined by each exchange).
Exhibit 3-1 provides an example of the marking-to-market process that occurs over a period of six trading days. We start with the assumption that the futures price is $100 when the transaction opens, the initial margin requirement is $5, and the maintenance margin requirement is $3. In Panel A, the trader takes a long position of 10 contracts on Day 0, depositing $50 ($5 times 10 contracts) as indicated in Column 3. At the end of the day, his ending balance is $50.~
Although the trader can withdraw any funds in excess of the initial margin requirement, we shall assume that he does not do so.”
The ending balance on Day 0 is then carried forward to the beginning balance on Day 1. On Day 1, the futures price moves down to 99.20, as indicated in Column 4 of Panel A. The futures price change, Column 5, is -0.80 (99.20 – 100). This amount is then multiplied by the number of contracts to obtain the number in Column 6 of -0.80 X 10 = -$8. The ending balance, Column 7, is the beginning balance plus the gain or loss. The ending balance on Day 1 of $42 is above the maintenance margin requirement of $30, so no funds need to be deposited on Day 2.
On Day 2 the settlement price goes down to $96. Based on a price decrease of $3.20 per contract and 10 contracts, the loss is $32, lowering the ending balance to $10. This amount is $20 below the maintenance margin requirement. Thus, the trader will get a margin call the following morning and must deposit $40 to bring the balance up to the initial margin level of $50. This deposit is shown in Column 3 on Day 3.
Here, we must emphasize two important points. First, additional margin that must be deposited is the amount sufficient to bring the ending balance up to the initial margin requirement, not the maintenance margin requirement.” This additional margin is called the variation margin. In addition, the amount that must be deposited the following day is determined regardless of the price change the following day, which might bring the ending balance well above the initial margin requirement, as it does here, or even well below the maintenance margin requirement. Thus, another margin call could occur. Also note that when the trader closes the position, the account is marked to market to the final price at which the transaction occurs, not the settlement price that day.
Over the six-day period, the trader in this example deposited $90. The account balance at the end of the sixth day is $130–nearly a 50 percent return over six days; not bad. But look at Panel B, which shows the position of a holder of 10 short contracts over that same period. Note that the short gains when prices decrease and loses when prices increase. Here the ending balance falls below the maintenance margin requirement on Day 4, and the short must deposit $35 on Day 5. At the end of Day 6, the short has deposited $85 and the balance is $45, a loss of $40 or nearly 50 percent, which is the same $40 the long made. Both cases illustrate the leverage effect that magnifies gains and losses. When establishing a futures position, it is important to know the price level that would trigger a margin call. In this case, it does not matter how many contracts one has. The price change would need to fall for a long position (or rise for a short position) by the difference between the initial and maintenance margin requirements. In this example, the difference between the initial and maintenance margin requirements is $5 – $3 = $2. Thus, the price would need to fall from $100 to $98 for a long position (or rise from $100 to $102 for a short position) to trigger a margin call.
As described here, when a trader receives a margin call, he is required to deposit funds sufficient to bring the account balance back up to the initial margin level. Alternatively, the trader can choose to simply close out the position as soon as possible. For example, consider the position of the long at the end of the second day when the margin balance is $10. This amount is $20 below the maintenance level, and he is required to deposit $40 to bring the balance up to the initial margin level. If he would prefer not to deposit the additional funds, he can close out the position as soon as possible the following day. Suppose, however, that the price is moving quickly at the opening on Day 3. If the price falls from $96 to $95, he has lost $10 more, wiping out the margin account balance. In fact, if it fell any further, he would have a negative margin account balance. He is still responsible for these losses. Thus, the trader could lose more than the amount of money he has placed in the margin account. The total amount of money he could lose is limited to the price per contract at which he bought, $100, times the number of contracts, 10, or $1,000. Such a loss would occur if the price fell to zero, although this is not likely. This potential loss may not seem like a lot, but it is certainly large relative to the initial margin requirement of $50. For the holder of the short position, there is no upper limit on the price and the potential loss is theoretically infinite.
Some futures contracts impose limits on the price change that can occur from one day to the next. Appropriately, these are called price limits. These limits are usually set as an absolute change over the previous day. Using the example above, suppose the price limit was $4. This would mean that each day, no transaction could take place higher than the previous settlement price plus $4 or lower than the previous settlement price minus $4. So the next day’s settlement price cannot go beyond the price limit and thus no transaction can take place beyond the limits.
If the price at which a transaction would be made exceeds the limits, then price essentially freezes at one of the limits, which is called a limit move. If the price is stuck at the upper limit, it is called limit up; if stuck at the lower limit, it is called limit down. If a transaction cannot take place because the price would be beyond the limits, this situation is called locked limit. By the end of the day, unless the price has moved back within the limits, the settlement price will then be at one of the limits. The following day, the new range of acceptable prices is based on the settlement price plus or minus limits. The exchanges have different rules that provide for expansion or contraction of price limits under some circumstances. In addition, not all contracts have price limits.
Finally, we note that the exchanges have the power to mark contracts to market whenever they deem it necessary. Thus, they can do so during the trading day rather than wait until the end of the day. They sometimes do so when abnormally large market moves occur. The daily settlement procedure is designed to collect losses and distribute gains in such a manner that losses are paid before becoming large enough to impose a serious risk of default. Recall that the clearinghouse guarantees to each party that it need not worry about collecting from the counterparty. The clearinghouse essentially positions itself in the middle of each contract, becoming the short counterparty to the long and the long counterparty to the short. The clearinghouse collects funds from the parties incurring losses in this daily settlement procedure and distributes them to the parties incurring gains. By doing so each day, the clearinghouse ensures that losses cannot build up. Of course, this process offers no guarantee that counterparties will not default. Some defaults do occur, but the counterparty is defaulting to the clearinghouse, which has never failed to pay off the opposite party. In the unlikely event that the clearinghouse were unable to pay, it would turn to a reserve fund or to the exchange, or it would levy a tax on exchange members to cover losses.