Wednesday, June 18, 2008

Speculative Margins

As the title bar states I am a trader in Chicago, I have spent years on the floor of one of Chicago's futures exchanges. The exchanges are not very well understood and have been blamed for high prices and low prices, shortages and surpluses, we just can't win. The subject of futures margins has been noticed by the media of late and that has brought a whole new level of ignorance to the subject. In an effort to help bring some reality to the debate here is a very quick overview: we trade standardized contractual agreements to buy or sell the product at the trade price during the future month specified in the contract, corn (5000 bushels of #2 yellow corn deliverable on a barge on the Illinois River) for July delivery settled at $7.42 and 1/4 cent per bushel today. The standardized months for corn are as follows: July, September, December, March, May, next July... Minimum margin level is generally about what you could lose in a day, today it is $2,025 for a 5000 bushel contract of corn. If you lose enough money you have to put up more money by the next day or your firm will liquidate your position, or "blow you out." That is why (good) firms demand more than the minimum margin to trade a given contract, the firm is on the hook if you can't make good on the contract. During unusual periods margin calls will be made multiple times during the day, a difficult proposition to those on the wrong side of the market but it keeps financial integrity in those markets.

Here is an important note, extremely volatile markets like the current oil and agricultural markets hold a great amount of risk (thus the possible rewards) not the least of which is "limit moves." The grain markets all have limits of how far prices can move from the previous day's settlement and during volatile times the markets can "lock limit", meaning that liquidation of a losing trade could be impossible. The limit situation is often a good circuit breaker or cooling off mechanism but it has also sometimes had the effect of feeding on itself. The threat of possible large losses that cannot be liquidated and the fact that the brokerage houses are on the hook for losses that their customers cannot make good on means that those brokerage houses make sure that their customers aren't trading on a shoe string. They are in the business to clear trades with the least amount of hassles possible not hire lawyers to sue their former customers.

 The primary use of these markets is to hedge price risk, they are used as insurance. Improperly priced insurance markets do not help the participants or society and efforts to impose government price controls on futures contracts should be opposed by all reasonable people. Unfortunately at least one of my Senators is not reasonable. Hat Tip on the Durbin article:Backyard Conservative.

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