All quiet on the margin front

On Thursday May 24th, the CME Group, the world’s largest commodities exchange, cut margins for trading gold, crude oil, RBOB gasoline and lean hog contracts, effective after the close of business on Tuesday , May 29th.

 

Initial margin on trading 100-ounce gold futures is to be lowered by 10% to $9,113 per contract from $10,125, the second cut this year. Margins for trading gold have dropped by 21% this year, including a cut in February. The drop of $1,012 per contract in gold margins when it is attributed to the total open interest positions is equivalent to nearly $1 billion less in margin escrow.

 

All quiet on the margin front refers to the lack of the usual uproar about margin changes but unfortunately it is only one-sided in the speculators’ eyes. I have watched with fascination over the last few years of the bull market in the precious metals when the margins have been raised, it has been accompanied by an uproar from the speculators and the letter writers who view it as a conspiracy to “curb excessive bullish speculation” and how the authorities are trying to calm the market. Last year when silver had a parabolic blow off rising to almost $50 and then falling just as quickly to $35, people were enraged at the margin increases when the price was actually falling. It would appear that many market participants are unaware how and why margins change preferring to believe in the authorities’ powers and the “dark arts”. The truth is unfortunately rather less exciting, verging on the banal.

 

Developed in 1988 by the Chicago Mercantile Exchange (CME), SPAN, The Standard Portfolio Analysis of Risk system was the first system to calculate performance bond requirements exclusively on the basis of overall portfolio risk at both clearing and customer level. It has become the industry standard and more than 50 registered exchanges use this basis for their margin mechanism.

 

Exchanges and clearing organisations using SPAN will use the following SPAN parameters to measure the required degree of risk coverage.

 

  • Price scan ranges – in effect, the maximum price movement reasonably likely to occur, for each instrument or, for options, their underlying instrument
  • Volatility scan ranges – the maximum change reasonably likely to occur for the volatility of each option’s underlying price
  • Intra-commodity spreading parameters – rates and rules for evaluating risk among portfolios of closely related products, for example products with particular patterns of calendar spreads
  • Inter-commodity spreading parameters – rates and rules for evaluating risk offsets between related products
  • Delivery (spot) risk parameters – for evaluating the increased risk of positions in physically-deliverable products as they approach or enter their delivery period
  • Short option minimum parameters – rates and rules to provide coverage for the special situations associated with portfolios of deep out-of-the-money short option positions
  • At least once every business day, each SPAN-using exchange or clearing organization calculates risk arrays for all of its products, and prepares a SPAN risk parameter file (also called a SPAN array file), containing all of the above data. These files are then published to clearing firms and other market participants. Using these freely-available files, and inexpensive software such as PC-SPAN, calculating performance bond requirements for particular portfolios is quick and easy.

 

While the details above are more relevant to a portfolio analysis of risk, the basics when it comes down to individual futures contracts are rather simpler.
The buyers (longs) have offsetting positions with the sellers (shorts) and all the contracts are settled through a clearing house. The clearing house is in the business of facilitating trade and covering its risk whilst doing so. It requests the longs and shorts to put into margin escrow held at the clearing house an initial (opening) margin amount per contract and then a maintenance margin( maintaining) to cover any additional calculated risk.

 

The important note here is that the clearing house is in the business of clearing contracts so  it wants to have the highest risk adjusted volume clearing every day. It is not a good business plan to raise margins so high as to reduce cleared volume unless it is coupled with a calculated risk profile based on the above parameters. It has to have enough money in the margin escrow to cover any losses that the individual positions might incur on the next day’s market movement.

 

Most people  understand that if you hold 10 gold contracts at a price of $700 and the margin is $5000 a contract, the $50,000 margin held at the exchange will cover a $50 (7.14%) adverse move in the market. And as such if the price of gold is now $1,400, having a $5000 margin and the same 10 contract position, the $50,000 would still cover you for $50 but that is now 3.5% adverse move not 7.1%. It should be quite obvious that the margin, just on the price alone needs to double to cover the same risk. What is less clear to understand is why the margin might change with the same underlying commodity price of even declining commodity price. This is when the “perceived risk” comes into the equation. The easiest measure of perceived future risk often comes from the option market in the form of implied volatility. Even if the market is unchanged, the option market might expect a larger move tomorrow than last week based on market factors. This will be picked up in the implied volatility and not the historic volatility, (click on chart for better viewing).

The 3 most easily quantifiable determinants of margin adjustments are:

 

  • Price of the underlying commodity
  • Historic and implied volatility
  • Biggest actual price change on an x-day look back.

 

The reason the CME has cut margins twice this year is because the reduction in all these factors as risk coverage needs decrease. We might well argue from time to time that its algorithm for margin adjustments has too much of an exit lag.(quicker to rise than fall), but always remember the clearing house wants to clear as many contracts as it can safely, not reduce business at will.

 

The next time gold and silver margins are being raised as the bull market continues and volatility picks up, remember it’s more likely to be computer generated than a “Voldemort” moment.

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