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Trading Commodities - Margins

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By : Amar Mahallati    99 or more times read
Submitted 2012-11-06 22:26:06
If you've been reading the newspaper lately, you've doubtless seen how much inflation has gone up over the last two years. You might be thinking, as many do, that this is likely to continue for the next two years. However, you can hedge your portfolio against inflation and maybe even pick up some profits by investing in gold.

Don't worry if you don't have $58,000 to purchase 100 troy ounces of gold at the current market price of $580 per ounce. Instead, you can buy a gold futures contract, as many speculators do. Instead of having to come up with $58,000, you only have to invest 5% of that total, or $2900.

That 5% initial investment is known as the initial margin. The exchanges and brokerage firms set the exact percentages on a daily basis. This is done per individual commodities futures contract. The exchanges monitor volatility, price and many other factors to figure out what acceptable levels of risk are. Then, they said the margins accordingly. The minimums are set by the exchange, but but brokerages will sometimes use requirements that are slightly higher.

If the price of gold rises by five dollars before the contract expires, that excellent. You've made five dollars per ounce of gold, times 100 ounces, which equals $500, excluding commissions of about $20. If you had purchased the gold straight out, you might be surprised to learn that your profit is exactly the same. However, look at the difference between doing an outright purchase and doing a futures contract in percentage terms.

$500 divided by $58,000 times 100% equals 0.86%, or just under 1%. This compares to $500 divided by $2900 times 100%, which equals 17.2%. This difference is from the effect of what is known as leverage. Even though you only invest 5% of the total purchase price, you get 100% (besides commission) of the profits, instead of 5% of the profits.

However, this is not only good with no bad. This type of reward carries risk of loss. Let's say the price had decreased five dollars and had never risen again before the contract expired. What you would have had would have been a $500 loss instead of a $500 gain.

Now, brokers have to protect themselves against the possibility of something like this happening, namely that you won't be able to cover your amount at contract expiration. Therefore, they do what's called a "margin call."

What this means is that all potential profits and losses are both calculated and settled on a daily basis. If the price drops under the minimum set by the broker, which is based upon the exchange minimum, brokers require that their clients deposit additional funds in order to bring their account back up to the level they initially had.

Now, here's the problem. Brokers may or may not give you enough time and notice to actually do that. Depending on what the price volatility is, the amount of money involved, and the quality of your relationship with them, brokers can and sometimes do liquidate your position and don't wait for you to cover.

Normally, most brokers will give you enough notice and reasonable time to cover this "maintenance margin," which is the amount needed to bring your account back up to the level they require. However, it's you, the trader, who is responsible for monitoring your own position and knowing what the guidelines are.

In addition to bringing your account back up to the previous level, you might also have to come up with even more money. Exchanges and brokers often do raise or lower the minimums they require, depending on what the current market conditions are.

Simply put, futures trading is fast-paced and puts you at higher risk in the world of commodities. It's not for everyone, but if you have a high tolerance for risk and can put additional funds in as necessary, and if you can withstand some losses as a matter of course, it might just be for you.
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