The Bullion Report For Oct 19, 2011: The Mechanics of Margin

Few people would argue that this year has been an important one for the precious metals trade. Gold approached and then marched through significant price milestones, making fresh highs before retreating on profit taking. Silver gained significant momentum and tried its hand at old price highs as well. Throughout all of this shifting price and volume, there were several changes made to the margin requirements for trading gold and silver futures. Let's take a look at these changes, and explore what the topic of margin is all about.


In many markets an investor will be required to have margin in a trading account. This is a feature of contracts traded on exchanges, including those for futures on gold. The purpose of the margin is to act as a performance bond. The funds deposited are used for initial margin to open a trading position. Maintenance margin is a dollar value, or level, specified by the exchange as the price point at which the account must be maintained as long as the trading position is open. The amounts are normally set by an exchange, by some brokers or clearing firms might ask for more. Why is this important to precious metals? The value of this information is two-fold.

The first thing that makes margin relevant is that it allows investors to leverage themselves into precious metals markets. This can be extremely risky. The risk exists because the overall contract value is normally many times what the initial margin requirements are. What this means is that the investor can lose much more than what they deposit into an account in order to invest in a particular gold or silver position. The flip side is that the margin allows someone to control, basically buying or selling, something that is worth more than the deposit. What multiplies the risk also multiplies the potential rewards. That is what makes the leveraged positions in precious metals appealing to someone with the appropriate level of risk tolerance. That is what can amplify the speculator activity when fundamental or technical forces collude to increase awareness or interest in precious metals markets.

If a contract for 100 ounces of gold is accessible via a portion of risk capital deposited in a trading account, then it might be argued that it makes the trade more liquid and viable for some investors than trying to buy 100 ounces of physical gold and store it in a safe or a bank somewhere. Of course that leads me to the second point about margin and what makes it relevant to metals pricing.

Since the markets are reasonably liquid, and participation and demand have likely increased with the global recession, there can be substantial reactions when fundamentals - including margin values - are changed. Back in the spring when margin values on silver were lifted rather high, there was a near-exodus of longs from the market. Why might that spark a closing of positions? The potential risk/reward scenario changes if you change the margin, as does the risk capital being tied up in the open position. That can change the profile of a trade and make it more appealing to cover it and close out the open position. Raising margin requirements may sound counterintuitive to price discovery, but for most exchanges it is an important part of the risk management in volatile times. In reference to increases in gold and silver futures market margins, the CME Group recently called those moves a part of a, "normal review of market volatility to ensure adequate collateral coverage." This can hardly be considered a fault in light of the extreme volatility seen in both markets in 2011 alone.


Summary

Margin has its place in trading, and it evolves to meet the needs and respond to the changes in the marketplace. The last several months have brought out what I would consider a very needy marketplace, one where precious metals are helping to fill the demands of investors looking for a place to put assets in a very unstable macro picture. Since the start of the year, silver margins went from around $6,750 to $24,975 and gold has ratcheted up from $5,739 to $11,475. Those are significant numbers, no matter how you slice it. However, there is still demand for gold and silver to diversify portfolios, add to reserves, and purchase in physical forms like coins, bars, or jewelry. These increases protect the interests of the markets to provide some kind of performance guarantee when an investor opens a long or short position. They haven't scared people off this form of investment, but they may still give pause to prices whenever a change is announced. There can be a shakeout of short term positions as margin calls are made and position closed. Overall, the main feature will be the demand for gold in the big picture, and that is where people will look for cues.

Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.