Commodities Concepts and Definitions
Commodities are the building blocks for producing goods and services. To use our cars, we need to process barrels of oil. When we eat we use crops like corn and wheat. To make clothing, we harvest cotton and produce wool.
Commodities are bought and sold in spot markets and futures contracts, or derivatives known as options on futures contracts (FOPs) can be used to manage the future pricing of the products after they are produced. Futures exchanges determine and set futures margin rates. Brokerage companies may also have margin requirements that are greater than the exchange requirement in order to control risk and exposure.
The margin is set based on the risk of market volatility. When market volatility or price variance moves higher in a futures market, margin rates tend to rise.
Most exchanges calculate futures margin rates using a program called SPAN, which stands for Standardized
Portfolio Analysis of Risk.
This program measures many variables to arrive at a final number for initial and maintenance margin in each futures market. The most critical variable is the volatility in each futures market. The exchanges adjust their margin requirements based on market conditions.
Commodities Margin Trading
Trading commodities on margin differs from securities. It is considered depositing collateral as a percentage of the value of the futures contract to control the position. It is otherwise known as a good faith deposit.
Commodities futures contracts often offer greater leverage by only requiring a deposit of 5-15% of the total value of the contract. Initial margin is the amount required to deposit at the time of entering the position.
When a loss on a futures position occurs, the exchange requires one to allocate more capital to return the
margin to the initial margin level.
If the market value of the position falls, the amount of the cash the investor is required to maintain will increase.
Benefits and Risks
Exchanges are regulated by the CFTC and have funds on hand to meet all obligations. Those funds come from
the margin payments collected by market participants.
However, the fact that futures exchanges offer high leverage is inherently risky.
Here’s a scenario based on a gold futures contract and how you might stand to gain by leveraging yourself on a futures exchange.
Charles buys one COMEX gold future contract when gold is at 1,270 dollars per ounce. Each contract is for 100 ounces of gold; the total value of the futures contract is 127,000. The initial margin percentage set by the exchange requires Charles to post 4,400 dollars to take on this position. Next, Charles sells one COMEX gold future contract at 127,500 dollars. The profit is 5 dollars per ounce or 500 dollars per contract. If Charles bought the actual gold and made a five dollar profit, that would be a 0.3937% gain, 5 divided by 1270 dollars. However, since he bought a gold futures contract using leverage, the gain is calculated based on the amount of margin posted for the trade, or 4400 dollars. The gain on this margined trade would equal 11.36% (500 divided by 4400 dollars).
Another example, this time illustrating the risk potential:
Chelsey is looking to open a position on a commodities futures exchange and speculate on oil futures contracts. Oil is currently trading at 82 dollars per barrel and crude oil contracts are for 1,000 barrels, for a total contract value of 82,000 dollars. Depending on the exchange, Chelsey might only have to post about 5,100 dollars to acquire a position in crude oil valued at 82,000 dollars. This is her initial margin. From this point forward, her account must meet the maintenance margin for her contract, as set by the exchange. That margin will rise or fall as the market value of crude oil rises and falls. If it falls below the minimum maintenance requirement, she will be subject to a margin call or immediate liquidation to bring her equity up to the original initial margin requirement. So for every one dollar that the price of crude oil moves, she could potentially lose 1000 dollars of her 5,100 dollars in initial margin per contract held (1 dollar price difference multiplied by the 1,000 barrels in the contract). Crude oil can move more than 2 dollars during a single trading day. A 2 dollar move equates to a nearly 40% change to the value of the position (2,000 divided by 5,100 dollars). If the price falls more than 5.10 per barrel, she may lose all of her posted margin and be required to replace the funds or have the position liquidated.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Margin Trading
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.
For additional information regarding margin loan rates, see ibkr.com/interest