Commodities Trading Margins

After reading the paper, and seeing the substantial rise in inflation during the past two years, you believe that this trend is going to continue during the coming two years. With this thought in mind, you decide to that it would be beneficial to hedge your portfolio by investing in gold, possibly picking up some profits.

Unfortunately, you don't have $58,000 to purchase 100 Troy ounces of gold at the current market price of $580. You instead do what most speculators do and buy a gold futures contract. This means that you only have to invest an initial amount of $2,900, 5% of the total, instead of having to come up with $58,000.

That 5% is known as the (initial) margin. The exact percentages are set by the exchanges and brokerage firms on a daily basis, per individual commodities futures contracts. The margins are set and based on prices, volatility and many other factors to determine acceptable levels of risk. Minimums are set by the exchange, but brokerages will sometimes have slightly higher requirements.

Now suppose the price of gold rises by $5 before the expiration of the contract. You've made $5 per ounce x 100 ounces = $500 (excluding commissions, around $20), and excellent investment. Purchasing the gold outright would have netted you the exact same amount of profit. But look at the difference between outright purchase and a futures contract in percentage terms.

$500/$58000 x 100% = 0.86%, slightly less than 1%. On the other hand, $500/$2900 x 100% = 17.2%. That difference is the effect of something known as leverage. You invested only 5% of the total purchase price, but (ignoring commission) you still receive 100% of the profits, not 5% of the profits.

Futures contracts do come with a high risk of loss. If the price had fallen by $5 and never rose again before the contract expired, the result would have been a $500 loss instead. To protect themselves against the possibility that you won't be able to cover the amount at expiration, brokers may issue something known as a 'margin call'.

Calculated and settled daily are all potential profits and losses. Where the price drops below the minimum set by the broker (based on the exchange minimum), brokers will direct their clients to deposit additional funds into the account to bring it back up to the level of the initial amount.

Here's the downside to this type of trade. Depending on the level of price volatility, the amount involved, and your relationship with them, they may or may not give you adequate notice and time to actually do what they have asked. Brokers can (and sometimes do) liquidate your position without waiting for your instructions.

Generally, most brokers will give you notice and a reasonable time frame to meet this 'maintenance margin', the amount needed to bring your account up to the required level. However it's the trader's responsibility to monitor his or her positions and know the guidelines, so in certain circumstances they will act without your prior approval.

In some cases, it’s possible you may have to come up with an even larger amount rather than merely bringing the account up to the original level. Depending on the current market conditions, exchanges and/or brokers can and do raise (or lower) the minimums.

Understandably, the high risks associated with futures trading in the commodity market means that this type of investment isn't for everyone. To trade successfully, you must understand the risks involved, be able to endure losses and have access to additional funds where necessary.

         

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