Silver Market Fall Sheds Light On Importance Of Margin


 

10 November 2010, 1:00 p.m.

(Kitco News) – When silver futures prices on the Comex division of the New York Mercantile Exchange fell sharply on Tuesday because of higher margin requirements, it underscored an important part of futures trading.

Margin requirements, also known as performance bonds, are different in futures markets than they are in other markets, like equities. To trade in futures, an individual needs to only put up a fraction of the total value of a futures contract. How much margin is required depends on each contract because of the value of the commodity and the type of trader. A speculative trader must put up more margin than a hedger. There is the initial amount of margin individuals must put down, but they also have a set amount of money available to maintain the trade.

A market participant gives their futures broker the proper amount of margin and the broker then gives it to the exchange’s clearing house. This margin is essentially a good-faith deposit that says the individual has enough money or other collateral to cover any trading losses. 

Tuesday, the Chicago Mercantile Exchange, which owns the Comex, hiked maintenance margins on silver from $5,000 a contract to $6,500 per contract, for both speculators and hedgers, effective Wednesday. The exchange also lifted the initial margin for speculators to $8,775 from $6,750 and to $6,500 from $5,000 for hedgers.

“The increases are part of a functionality of higher prices and/or volatility and we’ve witnessed silver move exponentially upwards; this is a market approaching $30 an ounce not $20 an ounce, and the margins are going to go into proportion to that,” said Ira Epstein, director of the Ira Epstein division of The Linn Group.

Raising margins when prices come more volatile is generally considered a safeguard for market participants and for the exchange, said Sterling Smith, analyst at Country Hedging. Smith said early in his career he spent two years as a margin clerk.

Smith said while some market watchers attributed the break in silver to the higher margins, he disagreed.

“When you raise margin, it only hurts those who are on the losing side of the trade. With silver having been up, the shorts were getting hurt, the longs were still profitable…. The gold silver ratio had fallen under 50, and people wanted to take some money off the table,” Smith said.

If an individual’s account falls under the maintenance margin, then they must add money to bring the account back up to the minimum, otherwise they are not allowed to trade. Anyone who might have gotten out of a position because of higher margins would likely have been short position holders would have had to come up with more money to maintain the position. Long position holders could either take profits and close the winning position, or have taken money from their profits to add to the maintenance position.

Smith said given that when December silver prices were trading around $29, it was about 20% above its trendline technical chart support. He also said that silver bulls were sitting on a very profitable position, even if they had entered the market last week.

“If you had gotten long silver just four days prior, you had a $5 profit – a $5 profit, at 5,000 ounces a contract, was $25,000. You have to understand from August 2009 to August 2010 silver was only in a $2 range,” he said. “When exchanges do change margin it can occasionally change the direction of the market for a few days. And smart metals traders know that gold and silver can fall very hard, very fast.”

Even with the increase in the maintenance margin to $6,500 per it takes very little upfront to buy a contract. Given the value of the contract, the margin only represents about 4.8% of the value. With a price of around $26.97 an ounce at midday, the value of the full-sized, 5,000 ounce contract is roughly equal to just under $135,000.  Smith said usually margin is about 5% to 6% of a futures contract value, depending on the contract and the market’s volatility.

Epstein said he thinks the margin should be higher, especially given the moves in silver. Just Tuesday silver had about a $3 move from low to high and if an unlucky trader bought at the high and sold at the low, they could have been out $15,000.

“I get very concerned with that, when I see moves like that. The exchange tries to balance what they think their algorithms are going to show is the average movements what the market will or won’t do. But when you get markets that go vertical, margining is an art, I don’t think it is a science, it is an art. And I am always in favor of higher margins than lower to protect the customer,” he said.

Bottom line, Epstein said, is that market participants need to exercise caution.

“The last thing the customer should be doing is trading the money in his account; he should be trading his positions. And that defines where is he right, where is he wrong, where should he be in, where should be out,” he said.

For a detailed description of margins in both futures and stock markets, visit: http://www.marketswiki.com/mwiki/Margins

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