What is Commodity Margin? How it is Calculated?

Commodity Margin

While trading in commodities, every buyer or trader must bear in mind that it represents a futuristic domain where the prices and the profit margins depend on long term options that one may have. This is where the concept of margin comes in. In stock trading, margin means the amount of money that a trader borrows to pay for a stock option. This money serves as collateral against the cost of a stock option. However, this is not so for a commodity market. In any commodity market, the commodity margin is the minimum amount of money that must be available with the trader before he/she can buy or invest in any commodity option. Here it can be thought of as collateral that allows a trader to engage in commodity trading. Commodities form a special class of assets in the sense that they can be used in combination with equity and debt assets. This allows a trader to have a diversified trading portfolio and lowers the long term risks associated with the volatility of the general trading market. So, commodity trading works in favour of a trader to diversify one’s portfolio, lower long term risk and increase upside potential.

By the very nature of offered products, commodity trading yields rich benefits for the investors and traders so that the overall gains that can be accrued from commodity trading cannot be thought of as existent in a traditional trading domain. This is why a fair understanding of various parameters like commodity margin, initial margin etc. are essential before one can start to trade in commodities. The fact here remains is that since in the present times, the global economic scenario is marked by a bit of uncertain fluctuations. Therefore, the safest bet is today’s times is to have a diverse portfolio that works best for you. This encompasses all the benefits associated with commodity trading. One of the primary advantages of commodity trading is that it acts as a hedge against inflation, even in a modest portfolio. The essential valuation of commodities tends to increase during times of high inflation on account of the general increase in prices and the cost of living index. This means that during such times when the inflation is on an increase, it is always thoughtful to keep a portion of your funds invested in commodities. Unlike markets thriving on equity options, the domain of commodities is rather rigid to the conformity of pricing and therefore represents a potential cushion against the effects of inflation in the long run.

Initial Margin

In simplest terms, the initial margin represents the minimum monetary reserve or the capital that one must have in his account to trade in the commodities market.

Now, theoretically speaking, the difference between spot and futures contract should decline over the life of a contract so that spot and futures prices are the same on the date of maturity of the contract. This therefore represents a “meeting point” of spot market and futures market, despite the fact that the mechanism of the two is way too different. In reality, price discrepancies between these two markets may exist due to excessive speculation and price manipulation in the futures markets. It has been estimated that about 75% of all futures contracts in the world fail due to their inability to accurately reflect spot market conditions. The threat that a commodity will not be delivered as foreseen in the contract is an important factor for preventing price convergence between the spot and futures markets. The regulatory authorities and futures exchanges can facilitate proper price convergence by ensuring that there is a credible threat of delivery of commodities. The threat of delivery is an important factor for facilitating price convergence between the spot and futures markets. It discourages the market participants from manipulating futures prices. Without the threat of delivery, futures contracts may not serve as a tool for price discovery and price risk management. Other measures to curb excessive speculation include the imposition of position limits and higher margins.

This is why the initial margin represents the starting safe bet for a trader and is set in accordance with the various variables of the commodity market.

Maintenance Margin

As a definition, the maintenance margin is defined as the subsequent amount of capital that must be contributed regularly towards the account for maintaining the initial margin. Therefore, the maintenance margin can be thought of as a secondary stage margin after the initial margin.

The impact on cash requirements and on the initial margin associated with trading in a specific commodity is to have a clear understanding of an upper limit or a threshold over the initial margin. This would directly impact the maintenance margin as well, besides offering a proactive method of judging what the initial margin on a commodity should be.

The legal capacity in which maintenance margin is held or exchanged can have a significant influence on how effective margin is in protecting a firm from loss in the event of the default of a derivatives counterparty. In particular, when two parties to a derivatives transaction exchange maintenance margin on a pre-calculated basis, the level of security of transaction between the two parties is not impacted as such and therefore, transparency in transactions remains secure. Although one firm has received maintenance margin as collateral, the firm also now bears the risk of additional loss on the initial margin that it has provided to the counterparty if the counterparty defaults, which may offset some or all of the benefits of maintenance margin received.

Calculation

Maintenance margin: There are guidelines that set the rules for the initial margin as being roughly up to 50% of the commodity stock worth, with the rest of the funds being paid by the brokerage firm. The same guidelines may set the minimum maintenance margin at 25% of the initial margin, even though there are firms that may require a higher rate.

 

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