commodities trading and margin: why volatility now?

commodities vs. stocks

Early in my career internationally, my boss gave me the assignment of studying the palm oil and soybean markets as a step in taking over responsibility for investing in the publicly traded plantation companies in Malaysia.  One of my first stops was a visit to the head of commodities trading for Merrill Lynch in Chicago.

It was like stepping into a parallel universe.

As an equity investor, I talked about remaining calm, not acting hastily and doing thorough research.  He talked about being in tune with the rhythm of the markets, reading the charts, developing good instincts, making decisions on gut feel and having lightning reflexes.  I spoke about hiring professional researchers; he said he looked for good high school or college athletes, regardless of academic accomplishment.

margin differences

Why the difference in outlook?  It may have something to do with the difference between dealing with global demand for natural raw materials vs. the actions of managers in highly complex, but focused, corporations.  But I think it has mostly to do with the, by equity standards, extraordinarily high levels of margin leverage that commodities market participants routinely employ in their investing/speculating.  It’s cold comfort to have the long-term trend absolutely correct but to be wiped out by a 10% price fluctuation in the wrong direction later on this week.

other quirks (from an equity investor point of view)

Two other characteristics of commodities trading to note:

–exchanges typically set the margin rules

–exchanges also typically set maximum daily price movements, both up and down, for a given commodity.  One consequence of this is that there are days when the price moves to the upper/lower limit without any sellers/buyers appearing.  In this case, the market can close for the day at limit up/down, but no trade.  So you can be “trapped” in a position you want to liquidate but can’t.  Another reason to act fast on new short-term developments.

greater interest in commodities

In recent years, there’s been a lot more interest in commodities than previously.  I see several reasons for this:

–the rapid economic advancement of countries like China and India, with large populations and at a stage of development where they use increasingly large amounts of farming and mining commodities.

–the rise of hedge funds, many of which are run by traders who are familiar with commodities and who are more comfortable “reading” charts than researching companies.

–the development of exchange-traded funds based on commodities, which give individuals easy access to commodity investing they didn’t have before

–the end to almost two decades of gigantic, price-depressing overcapacity in most mineral commodities created by overdevelopment in the late 1970s- early 1980s

–the increasing complexity of finance and the concomitant development of financial derivatives.

what’s going on now?

Why the sharp recent decline in mining and food commodities?

As I mentioned in my post yesterday on margin in general, a margin call can happen in two ways:

–either the value of your account can fall below the minimum margin level, or

–the market regulators can raise margin requirements.

margin requirements rising

The second hit the commodities markets late last month.  As the New York Times reported recently, that’s when officials at the CME (Chicago Mercantile Exchange) became concerned about the near doubling in the price of silver over the prior half-year.  The CME  immediately increased in the margin requirement for silver contracts.   When that had no immediate effect on the silver price, the exchange announced a series of increases that would rapidly bring the first-day margin needed to support each contract to $21,000+.

Each silver contract is for 5,000 ounces, or about $235,000 at a $47/oz. price.  Prior to these actions, the required first-day margin was $12,000-, meaning a market participant could leverage himself by 20x in buying silver.  (Actually, the allowed leverage was higher, since maintenance margin is lower than first-day, and because exchange members are permitted to use more leverage than speculators.)

Silver now trades for $34/oz., a decline of almost 30%, mos of the fall occurring in the first week after margin requirements were changed.

Other commodities have followed suit, though not to the extent of the decline in silver, as regulators have lifted margin requirements for them as well.

why act now?

Maybe the CME is just doing its regulatory duty.  A cynical person might speculate–à la the Hunt brothers–that pressure came from exchange members on the losing side of the trade.  Another (better, I think) guess is that there was pressure from Washington, where a new regulatory framework for commodity trading is now being developed.

Leave a Reply

%d bloggers like this: