Fluctuating Margin Requirements Impact the Volatility of Commodities


Carolyn Cui’s Wall Street Journal article entitled “Tripped Up by the Margin” makes the point that increasing margin requirements, a step sometimes taken by exchanges to reduce market volatility, can actually increase downward volatility as a result of ensuing forced liquidations.

“Whenever the margins are reacting to conditions, such as higher volatility, they can essentially exacerbate the impact of those conditions,” Craig Pirrong, a finance professor at the Bauer College of Business, University of Houston, was quoted as saying, adding: “It tends to reinforce the initial shock.”

Silver is a case in point, according to Prof. Pirrong. Commodities exchange operator CME Group recently raised margins five times over just eight trading days, increasing silver margins to as much as 12%, or $21,600 per contract, from 6%. Silver futures prices fell 25%.

“There’s no way that the market could handle it,” Neal Greenberg, a silver trader in New Jersey, was quoted as saying, adding: “Silver was on the ledge. CME basically shackled its legs with cement blocks and pushed.”

CME also raised margins on gasoline by 48%, resulting in a drop in gasoline prices of as much as 15%, according to the article. As prices of cotton rose toward $2 a pound, ICE Futures U.S. raised its margin requirement by 50%, according to the article, and prices fell 5% the next day.

Exchanges “should at least have some sort of recognition” of the impact, Prof. Pirrong was quoted as saying.

The way margin requirements are changed is regarded by some commodities traders as unpredictable and “couched in mystery.” The article says that exchanges usually consider a number of factors before changing margin requirements.

Some observers propose that margins should be a consistent percentage of the contract price, and that exchanges give more warning of any changes. Exchanges counter that greater transparency and warning would lead to traders “gaming the system.”

As an aside, the article repeatedly refers to “commodities investors.” A commodities option or futures contract is not an investment. Their purpose is to hedge a position in the underlying commodity or to speculate. They are unsuitable for, and should not be recommended or sold to, most retail investors.

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