Initial & Variation Margin
Given the recent run-up in base metal prices, we should have a look at exactly how hedges for those positions are financed. For every futures contract executed, the LME (and therefore your broker) requires a down-payment in order to cover a percentage of the value of the trade. This payment is known as Initial Margin (IM).
The amount varies by metal but as of the time of writing, for every lot traded IM on the LME is: Aluminium Alloy: $8,700; Aluminum: $5,400; Copper: $13,500; Cobalt: $7,588; Nasaac: $4,900; Nickel: $18,000; Lead: $3,625; Tin: $17,200; Zinc: $5,675.
The full value of the futures trade is only paid/due at the time of settlement. So a 1,000 lot copper position at a price of $10,000/mt that has a nominal value of $250,000,000 only requires an IM payment of $13,500,000. Coming up with $13.5m is a lot easier than $250m! This is known as Leverage - your trading position value is larger than the cash you need to execute the trade.
Once the trade has been executed and the IM is financed, trading firms face another type of margin - Variation Margin (VM). VM is a continually changing figure defined by the current market price (typically the closing price each day) vs the executed price of your futures trade. For example, if you sold 1 lot of copper @ $9,000/mt, and the current market price for copper for the same prompt date is $10,000/mt, that futures trade would carry a negative variation margin of $1,000/mt. Given trading companies trade significantly more than one lot at a time, you can see how quickly margin can become an issue for companies that aren’t well financed, and don’t manage their positions well.
These margins are typically managed under credit lines with brokers. Brokers may charge interest on these lines as they are essentially loans. This is one of the costs that you may not have considered when thinking about trading as it doesn’t usually hit any P&L that you see. When your trader says that it costs $X/mt just to trade a metal, it’s behind the scenes costs like this that make up that value.
Once a company’s VM or IM is over their credit limit, they will be required to finance that position in cash by 9AM London the following day - this is what’s known as a Margin Call. In extremely volatile times, it is not unheard of to face an intra-day margin call as brokers try to reduce default risks. Companies will receive notice from their broker with the amount owed. Failure to pay promptly has catastrophic consequences for company’s credit standing and trading ability.
Trading firms are typically long physical before they are short physical, so in general they are inherently short futures and their margin will be negatively affected by rising markets, and positively impacted by falling ones. With rapidly rising prices, the pressure on trading firms can be immense as they can be margin called on a daily basis with each subsequent price increase.
