Financial writers and TV reporters require an authoritative presence to capture their audience. Sometimes, in the pursuit of sounding important, they borrow facts from one story to make the case for another. This was the case last week when it was commonly reported that the commodity exchanges were raising margins to shake out the speculators. Many reports stated that higher margin requirements were forcing small speculative traders out of the silver market and this was the cause of the rapidly falling prices. I say the commonly reported cause did not create the end effect.
First of all, a quick understanding of margin is necessary. Margin in the futures market is not like margin in the stock market. Margin in the stock market is money the clearing firm lends, with interest, to someone who wants to purchase more assets than they have cash in the account to do. This makes the borrower responsible for the extra positions purchased with the margin money as well as the interest charged to them for the money they’ve borrowed to create them.
Futures margin is a performance bond placed with the exchange by both the buyer and the seller of a commodity contract. This money is an equal amount supplied by both parties and is held by the exchange to guarantee the obligation of both parties. No interest is charged to or by, any of the parties involved. Think of it as the exchange holding funds in escrow until the trade is offset and settled. The amount of money required for margin is based on a mathematical equation developed by the exchange. It is designed to protect and insure the exchange’s solvency by knowing that the buyer and seller can both meet their obligation. The amount fluctuates according to how much and how quickly a market is moving.
Since there is no, “charging,” of margin, raising margin requirements applies equally to both the buyers and sellers. Therefore, it cannot have an unequal impact on the market’s participants. Mathematical equations are not emotional.
The second flaw in the reported cause of silver’s decline is that forcing out the speculators will drive down the price. The Commodity Futures Trading Commission has a weekly report that tabulates the number of positions held by various trader groups. These groups include, small traders, managed money, commercial producers and users as well as large traders and spread traders. Small traders show up in the, “non-reportable,” column of the report. Their individual positions aren’t large enough to meet the market’s reporting level.
Silver at $40 per ounce has a cash value of $200,000 per exchange-traded contract. Every small trader in the report has at least one contract. How many small traders do you know who own $200,000 worth of silver? The record net long position for small traders in the silver market was 35,847 contracts. That was set in April of 2004 when silver was trading at $6 per ounce – a cash value of $3,000. Currently, small traders hold just under 20,000 total contracts. This represents approximately 15% of the total open interest in the silver futures market.
Silver prices fell more than 30% last week. Would this be physically possible by wiping out the entire small trader population, which holds 15% of the market’s open interest? Once again, unbiased math makes it a physical impossibility. Next week, we’ll start with a discussion of who the real players are in the market and their effects on market tops, bottoms and news events. We’ll discuss the true cause and effect of the enormous swings in commodity markets and why they’re here to stay. You might be surprised.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
