Commodities | May 03 2006
By Greg Peel
If you don’t buy copper with the intention of using it, you are buying with the intention of speculating on the price. Instead of buying actual copper, you buy copper futures. There are two reasons why this is convenient: you need never take delivery, and you can leverage your investment.
When one buys a copper futures contract – indeed any futures contract – one does not pay the full face value of that contract, but merely puts down a deposit with the relevant exchange. If the price goes up, the exchange is happy. If the price goes down, then you need to top up your deposit with further funds to protect the exchange against you not being able to cover your losses. It is the exchange, not the seller of the contract, taking the risk. The amount required for top-ups is a predetermined amount per contract based on what the exchange considers to be a potential ugly overnight move in price. This amount is known as a "margin". When your account balance drops below the line, you are "margin called" by the exchange.
It also works the other way around for short positions – margins are required against sharp upward movements in price.
Margins are not set in stone, but rather are readjusted by the exchange from time to time. The determinant of the level of margin is the perceived level of volatility in the market. The more volatile the market, the more ugly the overnight move might be, the greater the margin required by the exchange.
The copper price has recently been going up and up and up with the occasional down, as witnessed late last week. The down was short-lived, but clearly volatility has risen lately. This means a reassessment of margin calls.
Last week the Comex exchange in New York increased its copper margins by 50%, from US$4000 to US$6000 per 25,000 lb contract (copper spot month closed at US$345.30/lb yesterday). As soon as this occurred, all eyes turned to the other big copper market, the London Metals Exchange.
And it didn’t disappoint. The London Clearing House raised margins on the 25 tonne contract from US$6700/t to US$14575/t, a rise of 117%. London was closed yesterday for May Day, so Friday’s close was US$7050/t.
So what might ensue? BaseMetals.com suggests the initial response to the margin hike, all other things being equal, would be a quick rally as short positions were covered to avoid the extra margin call. Thereafter may, however, prove more interesting.
Hedge funds, commodity funds and purveyors of various commodity-backed instruments will have to have a good look at their books. While the amount of leverage inherent in each position will vary, it is possible such positions (held responsible to a great extent for the copper price rally), may need to be shaved somewhat to incorporate the higher margin call factor.
That is not to suggest collapse is the next move. Some of these funds are so big now any major selling would be like turning around the Queen Mary. They are after all "long" funds. However, a period of adjustment is on the cards as unwinding may occur over the next few weeks or so.
On the other hand, all the signs, all the reports, all the evidence is for ongoing bullishness. In raising margins, both the LME and Comex have clearly attempted to protect themselves as well as take some heat out of the market. What they might achieve, in the short term, is increased volatility.