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 $30,000. 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.
