What recent margin raises mean for CTAs (hint: nothing)

The CME has kept the hits coming this week, raising margins on Crude Oil this time, after 5 consecutive hikes on Silver the week before that. Whether last week’s commodity sell off and the sell off part two, today; are because of these hikes has been in debate across the airwaves.

We’ve written in this space before regarding why margin raises happen the way they do, but in light of a number of new articles springing up from the New York Times to Seeking Alpha alleging price control efforts, we thought we’d take another shot at explaining the process.

When prices in a given commodity are soaring sky high, the CME gets nervous, and rightfully so. But they aren’t nervous because the price is going UP.  It has nothing to do with the direction of the move, but instead what a higher price represents. Imagine someone moving into a nicer home which is twice as expensive, and then calling their insurance agent to up their home coverage amounts. Do you get more insurance because you are trying to drive the price down of your home – or because you need more insurance because the price of your home is now higher.

Margins are the CME’s “insurance” against the players in the market not being able to cover their trades.  They are nervous because they are guaranteeing the other side of every trade , and are asking for more of an insurance premium because these markets have moved into pricier territory.  That’s it, in our opinion. Not some conspiracy theory to pop a commodity bubble or fight the fed.

But whatever the motives for margin hikes – the question remains… were they the cause of the sell offs today and last week? To what extent does it push people out of the market? And which people does it push out?

Good questions. First off, the amount of people being “pushed out” was likely not a huge number, but also not insignificant.  Just looking at open interest, there was certainly a drop in contracts held, but the drops were not the wide scale plunge that others have been gushing about. Looking at silver and crude, the two commodities affected most by recent margin hikes, you’ll notice that open interest only dropped 10.29% in silver, and only dropped 8.65% in crude between 5/4 and 5/9. Substantial? Maybe. Earth shattering? Hardly.

So who are the people getting pushed out? It looks to be mom and pop speculators (and perhaps levered up hedge funds) instead of the professionals running managed futures programs. We ran a quick straw poll amongst our recommended CTAs to find out if the recent margin increases had caused them to exit positions.

1. Have the recent margin increases caused you to exit any positions?

Yes         0/17    0%                             No    17/17   100%

1. Have you ever had to exit positions because of a margin increase?

Yes         0/17    0%                             No    17/17   100%

These stats fly in the face of those blaming the speculators for price increases and offering up margin increases as a way to keep them at bay. The professional speculators (managed futures) aren’t really affected at all by this.

Why is that the case? Robby Stamper of James River Capital Corporation put it best:

“In our trading program, the bulk of our assets are in the form of cash, and we have never had any historical problem with posting margin, whether the margin rate is 5% or 20%….In our opinion, only traders that trade one or two markets with extremely high margin to equity ratios would have to sell contracts to meet margin calls.”

Well put. Stamper also points out that there is more to this story than just how high or low margins are, saying that it is the changing of margins which can be most unsettling for markets- not necessarily their absolute level.“My preference is to have high margin rates that don’t fluctuate.   In my experience, when margin rates are low (5%), traders build large speculative positions, and margin rates rise (20%). When these two things occur, it does “shake out” some traders and their selling creates more volatility and more selling…   I would prefer that margin rates were kept higher and more stable.   In variable interest policies, low rates create asset bubbles and high rates pop them; likewise, variable margin rates create volatility because of increased uncertainty for the future.”

Great point here. It is not too hard to imagine a hedge fund which has structured a trade in which they borrow money at x% rate, post it as margin to go long a commodity, with some interest hedge, and some other form of collateral for the loan – but with the whole thing based on a set amount of margin. When that set amount changes drastically – it isn’t forcing such a trader out because they can’t afford it- it would force them out because they haven’t modeled for it (because they haven’t structured their trade around the new level).

PS – by the time we finished writing this, the CME raised rates on RBOB Gasoline another 21%…