Commodity Futures contracts are traded on central exchanges all around the world such as the Chicago Mercantile Group (CME Group), Intercontinental Exchange (ICE) and a host of others. We are trading contracts that call for taking or making delivery of a physical Commodity at a specified date and predetermined price. These contracts each have their own unique specifications and of course, contract values in dollars. The dollar values of these contracts are tremendously large in some cases. Table 1 shows a few examples of these contract values.
|Market||Current Contract Value in $s|
Fortunately, Futures traders are not required to have the full value of the contract to trade them. A Futures trader must meet a minimum margin requirement of about 3-9% of the contract value. In some cases, the metals markets, this number is a little higher due to the extreme volatility. Margin is sometimes referred to as a Performance Bond. This cash is used to assure the broker, or clearing firm, that the customer is good for any losses they may have while in a particular trade. Table 2 shows the margin required to trade the Gold contract.
From Table 1 we see that the current contract value of Gold is $169,600. The margin needed to trade a Gold Futures contract is $10,125 to initiate the trade. After the first day you hold the position, that amount gets reduced to $7,500. For about 4.5% of the total contract value, a Futures trader can trade this Gold contract.
But how did the CME come up with this $7,500 value and what will make it change?
Margins are just one of the risk management tools that clearing firms such as CME Group and ICE use to protect the individual investor and provide security to the markets. Let’s look at some of the policies affecting margins on Futures products.
- Clearing Firms have regular routines for margin changes
Margin levels are set to cover approximately 99% (3 standard deviations) of the possible price moves for a position in a trading day or multiple trading days.
During volatile periods in a market, a clearing member like the CME Group will generally raise the margin to account for the perceived risk. Some of the factors that could contribute to this volatility are:
- Supply/Demand shifts (fundamentals, not the Supply/Demand on charts)
- Changes in fiscal policy
- Major Geopolitical events
- Natural disasters
When the daily volatility decreases, margins typically go down because the perceived risk is lower for traders holding open positions.
We all remember when Silver traded up to $50 per ounce in almost a parabolic straight up move. This raised the volatility levels so severely that the exchanges had to increase the margin levels 11 times over the past year. To put that move in perspective, the value of the contract was approximately $45,000 before the bull move. At the top of the move, the same contract was worth approximately $250,000. During the same time Silver was in a run-away bull market, the Copper market was relatively flat thereby reducing the volatility and risk to open positions. The exchanges actually lowered the margin requirements two times during the same period.
- It’s not what the price level is that determines the margin, it is how volatile the price action was on the way to this level
Exchanges review the volatility daily to make adjustments to margins. More volatility leads to higher margins, while lower volatility will lead to lower margins.
Many times it appears that when an exchange raises margin levels, it is an attempt to control the price action and possibly stop a price trend. But the exchanges are not trying to manipulate prices, they are simply protecting investors and markets when the volatility becomes excessive. Raising margin provides additional layers of financial resources to reduce the impact of these large price moves.
The CME Group reported that in early March 2011, crude oil margins were raised two times over the next six days representing a 33% margin increase overall. Following these margin changes, prices continued to trend higher within a $10 range over the next month. This demonstrates that raising margins does not always deter price action (trends). Exchanges are neutral participants in the financial markets – it is their intention to protect the market whichever way it moves. Also, they want to ensure that each participant has enough capital to protect against price moves each day.
There are approximately 50 other global exchanges that use the same system for determining these margins. This will help keep some consistency around the world. The chosen system is the CME Group’s “Standard Portfolio Analysis of Risk” (SPAN) to assess the markets. Using SPAN around the world will help ensure that margin rates are relatively the same during trading in different time zones.
Exchanges will look at three different kinds of volatility to make their decision on margin rates:
- Historical Volatility – Price changes from one day’s close to another
- Intraday Volatility – Price changes within a market session, regardless of whether there are price changes from close to close
- Implied Volatility – Forward looking measure of potential volatility derived from analysis in the Options markets
Exchanges will also review other factors such as liquidity, seasonality, current and anticipated market conditions and any other relevant information they see fit for determining margin levels.
The CME Group will typically make changes to margins after the markets close in order to have a full view of that trading day’s market liquidity and volatility. However, exchanges have been known to raise margins intraday due to severe volatility (crude oil 2007). Market participants will usually have 24 hours notice of these margin changes to give market participants time to assess the impact on their positions and add additional funding if needed.
The CME Group offers an email notification of margin increases at the following link:
Enter your email address on this page and when you get on the next page, you have the option to select the free subscriptions you would like. Look for “Margin Updates.”
This is a good service to have. When Silver margin was increased before the big sell-off, it was emailed over the weekend before the Sunday night open, giving people in the “know” a heads up to expect liquidation of positions. Others did not get the information until the talking heads on TV mentioned it Monday morning. And we all know that reacting to news from TV is going to make you late every time, this was no exception.