Commodities | May 13 2006
By Greg Peel
On May 3rd FN Arena reported (Copper Margin Rises May Spark Volatility) that the major metal trading futures markets of New York and London, COMEX and the LME, had made significant increases to copper contract margin levels in a fairly tardy response to increased volatility.
A margin is that amount required by the exchange to be held in a client’s account as insurance against adverse moves in futures prices. Futures contracts are by their nature leveraged instruments.
The question then arose as to whether this might result in a bit of a copper sell-off, given that the speculative money is vastly long and positions may need to be shaved to allow the topping up of deposit accounts ahead of potentially onerous margin calls. The call made here was not for some sharp, one-day correction, but for some more medium term position management.
Well if that position management has occurred at all you wouldn’t know it. Copper has only accelerated its upward pace since. One might conclude that many speculative long accounts are so flush with profits that increased margins pose no immediate threat. However, the threat is only becoming more dire.
The question, at least for copper, is whether the latest margin increases actually stand up against more recent price explosions. Market-watcher Dennis Gartman notes that over Thursday and Friday last week, copper was at times moving by US$100/t in mere moments. It wasn’t that long ago that US$100/t was the trading range for an entire quarter!
Brokers, banks and particularly exchanges will likely be looking hard at what positions their leveraged clients are holding, in all base metal markets, and whether their account balances offer sufficient insurance against this level of volatility. Margin increases will have to be on the agenda.
Then we come to precious metal markets, which have not seen any recent margin increases. As with base metals, the bulk of global gold trade occurs in futures contracts in New York. (London provides a major physical market).
On Thursday, Dennis Gartman notes gold rose US$25/oz in fifteen minutes. As early as last year, a US$25/oz move would be considered one entire leg of a bull market. Silver moved more on Thursday than it has done so in the past over a period of years.
Base metal markets are known for their brief periods of extreme volatility, mainly due to sudden supply shifts. Most experienced speculators would be aware of this, and trade accordingly. Precious metals, on the other hand, rarely exhibit the same levels of volatility except in brief periods of global scare. Chernobyl is a good example. So is Iraq’s invasion of Kuwait.
Even taking into account Iran, Nigeria, and general inflation fears, the gold market in particular is moving like there’s a nuclear reactor blowing up every hour. And the force behind these moves, as well as the moves in base metals, is the weight of new money from direct investment. There is an army of greenhorn mums and dads throwing everything they’ve got behind the latest craze.
Dennis Gartman said on Friday "we are certain that there are massive margin changes due to be made in nearly all of the markets sooner rather than later," and that "a swift, violent round of liquidation almost certainly will follow".
It is unlikely the bulk of the new money investors even really understand what a margin is, what a futures contract really is, or what perils may await late entries into the market. Their fund managers, brokers, bankers and exchange administrators will however know all too well. Gartman also makes note of one of the most popular correction indicators of any market.
And that is that everywhere, everyone is talking about gold. In the country clubs, by the water-cooler, in cabs – there is vibrant chat about how gold investments are fairing, and concern from those left out as to whether they should be getting in. This is the stuff of market tops, and, as Gartman suggests, an indicator we are in the last 10% of an upward move.
Correction has been the call for most of this year, mainly in base metal markets. Apart from a couple of blips, nothing has happened. Now precious metal markets are resembling their base cousins. Every healthy bull market (and there is little doubt around the traps that we are in anything but) needs a good correction. Shake out the shaky longs, scare off the pretenders, and take out that element of fear for now.
The longer a market surges upwards the more likely an inevitable correction is of a greater magnitude. This is not a doom and gloom scenario – just market mechanics. It is still quite possible gold, for example, will continue spiralling upwards for awhile yet, but something will set off a sell-off eventually, and margin increases just might be that trigger.
One thing is for sure and that is we’ll be in for another volatile day on the Australian bourse. While metals markets are again higher, the Dow Jones fell another 115 points on Friday.