05 May 2011, 1:16 p.m.
By Allen Sykora
Of Kitco News
http://www.kitco.com/
(Kitco News) - Futures-industry veterans say the margin hikes undertaken in silver lately by CME Group were necessary to protect the exchange, clearing firms and the market itself since big gyrations in the value of a single futures contract were at times exceeding the old margins.
CME Group late Wednesday announced a margin hike for silver for the fourth time in the last two weeks.
“Being a former margin clerk, I fully expected that and am not surprised by it,” said Sterling Smith, commodity trading advisor and futures analyst with Country Hedging.
“It’s there to protect the brokerage firms and it’s there to protect the exchanges. Given the sheer and utter violence of the move and up-and-down volatility that has accompanied it, you don’t want anyone in here trading who isn’t really properly capitalized to do so.”
The margins even “protect people from themselves” by keeping them out of positions during times of extreme volatility when they might not have the capital to cover losses, Smith explained.
“They can’t go running into the burning building,” he said. “You don’t want someone who isn’t prepared to take a $15,000 or $20,000 swing that can occur literally in a matter of a couple of hours.”
While much of the focus in the market is on the CME hike for its Comex metals division, the Shanghai Gold Exchange also announced overnight that it increased the margin on its silver forward contract for the second time in two weeks.
In futures markets, traders put up a margin that acts as “good-faith money” to hold a contract. Some might compare it to a down payment on a house. This tends to be a small percentage of the total value of a futures contract, which creates both enormous profit potential but also huge risk potential. Suppose the margin amounts to 5% of the value of a contract. A trader would double his money if the market moves in his favor by 5%. Conversely, he would lose all of his money if the market fell by 5%.
“When the daily swing of a move–from a closing price to a high or to a low—exceeds the good-faith money that a client puts up, that’s means volatility has picked up so much that the changes step in and raise the amount of good-faith money that a customer has to put up,” said Ira Epstein, director of the Ira Epstein division of the Linn Group.
The recent margin hikes were “needed because volatility was picking up too dramatically,” Epstein said.
He and Smith pointed out there have been a number of times lately where the market was moving more in one day than the existing margin. This creates the risk for default on a contract.
The recent moves in the silver price, when multiplied by the 5,000 ounces in a single full-sized contract, has meant a number of swings in the value of a single futures contract lately of $15,000 to $20,000, Smith said.
One trader pointed out that when silver plunged from $48 to $42 an ounce shortly after electronic trading began Sunday night, this would have meant a sudden loss of $30,000 on a single contract for somebody who had bought at the high.
Yet, the “initial” margin—or amount of money somebody had to put up to open a position—as of the end of last week stood at $14,513 for a speculator. The “maintenance” margin for speculators, and margin for all hedgers, was $10,750.
With the most recent increases announced by CME Group late Wednesday, the initial margin for speculators will be $18,900 as of the end of business Thursday and $21,900 Monday. The maintenance margin for speculators, as well as margin for all hedgers, will be $14,000 at the end of Thursday and $16,000 Monday.
CME Group posted a column on its Web site Wednesday saying margin requirements are adjusted frequently in all of its markets, based on volatility.
“When daily price moves become more volatile, we typically raise margins to account for the increased risk,” said the column. “Likewise, when daily price moves become less volatile, margins typically go down because the risk of the position also decreases.”
In more than a century, there has never been a default, CME Group said. CME Clearing tries to calculate the worst possible loss a portfolio might reasonably incur in a set time period, normally one trading day for futures markets.
“Margins are set as part of the neutral risk management services we provide,” CME Group said. “They aren’t a means to move a market one way or another, or to encourage or discourage participation from one kind of market participant or another. Rather, margin is one of many risk management tools that help us assess overall portfolio risk to protect market participants and the market as a whole.”
Bill O’Neill, one of the principals with LOGIC Advisors, also said silver margins were “necessary” given the recent price action.
“Its purpose is to try and balance the market and create an orderly market,” he said. “But it’s a very delicate process because if you overdo it, you can ramp up the volatility. If the market is going one way or the other, it pushes it even more in that direction.
“In my opinion, they waited too long to really aggressively hike them. But certainly they were justified.”
He pointed out that individual firms, for their own protection, can set even higher margins for their clients than the exchange requires, and this in fact has been occurring. “The margin is the exchange minimum,” he said.
Margin hikes apply to all market participants, whether they have short or long positions and whether they are speculators or hedgers.
The recent price response to the margin hikes has meant silver weakness in what had been a bull market, as many speculators choose to exit long positions rather than ante up more good-faith money. The decline in turn triggered some sell stops, which are pre-placed orders triggered when certain chart points are hit.
However, margin hikes have also occurred in bear markets. Epstein recounted that margin increases a few years ago limited a steep sell-off in grains.
“It’s a way that exchanges use to control volatility,” Epstein said.
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