So Little for So Much
So Little for So Much
How about this volatility in the Futures markets that we are experiencing? Some point to events like geopolitical and natural disasters for causing this elevated volatility. Day and swing traders alike are feeling the stress from this added volatility. Regardless of the reasons for this paradigm we are in, one thing is for sure: The risk has not been ignored by the government and the Futures exchanges.
The Chicago Mercantile Group Exchange (CMEGroup) constantly monitors this added risk due to market volatility across all Futures markets that trade on their exchange. With their acquisitions of the Chicago Board of Trade, New York Mercantile and Comex exchanges, they now have better than 85% of the world commodity Futures traded on their electronic Globex platform, or an open outcry trading pit, at one of the three exchanges. For over 100 years, the CME has cleared trades and been a counterparty to every transaction on the exchange every day for this period. For the record, in 2010, the CMEGroup cleared 2.4 billion contracts. Being a counterparty means that for every transaction made, the exchange will guarantee each buy or sell side transaction. If, for some reason, the party on the other side of your trade defaults on their obligation to honor their losses, the CMEGroup will make that transaction good by paying the loss to the winning party of the transaction. During this 100 plus year period, there has never been a failure of a clearing firm member resulting in losses to a customer account.
Why the CMEGroup monitors this volatility on a daily basis is to asses a margin rate for every Futures contract traded on their exchange. This margin amount is part of the risk management used to protect traders and investors. Recently, the exchange raised margin on the Gold contract for traders/investors who held Gold contracts overnight. After the Gold market had made a 35% increase in a very short time, I would say it was about time. However, many around the world found this margin increase to be a form of currency manipulation by the United States government. Most of the people complaining about this margin increase were the usual undercapitalized traders who were forced to exit their positions because they had acquired too many contracts on margin using leverage from open trade equity. Little do these traders realize that when the exchanges see a danger to investors, they will do their best to get the weak hands (undercapitalized traders) out of the markets simply because there is a good chance the market could see volatility in the near future that could literally wipe out these undercapitalized traders.
Margin is a percentage of the Futures contract value that you must have available in your trading account before you can hold a Futures contract past the regular trading hours session. Usually anywhere between 3 ñ 10 % of the contract value is what margin amount you will need. For example, Corn currently trades at 767'0. The multiplier is $50. Therefore, one Corn contract has a dollar value of $38,350. If a speculator wanted to hold a Corn contract past the regular trading session, they would be required to have a minimum of $2,363 in their account for each contract held. This is all you need to control $38, 350 worth of Corn! The margin on Corn is currently a little higher than usual compared to other times of the year. This is because we are just ending the critical growing season for Corn. There are so many variables (weather, crop damage from insects, supply disruptions, etc) that could cause prices to become extremely volatile and anybody who has traded Corn this year knows what I mean. With uncertainties, there will be volatile prices leading to higher margin requirements. Once the crop is harvested and put in the grain elevators, there is little to damage the crop and the price will be driven more by normal supply/demand distributions until the next planting season next year. During this period of safety for the crop, the margin rate will probably go back to its usual per contract $1,000 margin. The price volatility will decrease once the crop is stored, hence, the lower margin requirements.
The CMEGroup uses CME Clearing to set these margins. Several factors are taken into consideration for increasing and or decreasing margins on a daily basis. One of the factors is how much a trader/investor could lose during a trading day.
The Futures markets are marked to the market twice per day in order to monitor all open positions during the day. This allows the exchanges a way to monitor a speculator's account, and if it becomes undercapitalized due to any losses, the speculator will be issued a margin call immediately. The margin call allows the speculator to replenish their trading account and keep the position open or to have the brokerage firm liquidate the position for them.
At times of high volatility, the exchanges will increase the margin rate to adjust for this volatility. These increases generally are announced 24 hours before they become mandatory. This allows traders time to make adjustments to their accounts for the new margin requirements, whether by adding more funds to their accounts or liquidating some contracts to make room for the higher margin rate. If you have a Futures position open and there is an increase in margin, you are still required to have the new higher margin amount in your account.
In the case of Silver, CMEGroup made several changes in margin rates during a series of weeks to adjust to volatility in the marketplace. By the close of business Thursday, May 5, the margin when a position was initiated was $18,900; throughout the life of that trade, CMEGroup would expect $14,000 in maintenance margin would be kept at the clearing house. By the close of business Monday, May 9, the margin when a position is initiated was now going to be $21,600, and CMEGroup would expect open positions to keep $16,000 in maintenance margin at the clearing house. Looking at a Silver chart (Figure 1), we can see that the most recent top in price action was when margin was increased. Notice how the Silver chart shows how parabolic the price action was to the upside. This caused alarm for the exchanges because they saw a speculative bubble forming and wanted to get undercapitalized traders out quickly to reduce risk.
Figure 1
Recently, I was asked if this volatility is something that will go away. Personally, I don't think it will. With electronic trading making transactions so easy for participants, we have everything from computers placing orders to humans. With globalization, we can expect more volatility as other countries impact our markets as much as we do theirs. Wealth around the world is growing, too, and this means that people are given money to manage for these wealthy individuals and the Futures markets seem to be a place this money gravitates towards. And, of course, we have the wonderful Exchange Traded Funds (ETFs) to contend with. Someday perhaps we will get rid of them or perhaps get better regulations regarding their hedging in the Futures markets. With all these variables (and these are only some of them), I believe we need to adapt to this new era of volatility and manage our risk. With the help of the exchanges watching this risk and adjusting the trading capital (margin) required to trade, we can tell when a market is too volatile for us.
"The more reasons you have for achieving your goal, the more determined you will become." Brian Tracy
Wishing everybody had a great summer,
- Don Dawson
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