The Comex margin adjustment – a rabbit?

On occasion, when the commodity underlying some futures contract experiences much increased volatility, the futures exchange decide to be prudent and to increase the amount of margin required for that contract. The well-founded reason for doing so is to reduce the risk of default by some players should the price vary across a wide range. Generally, though, the intended increase is announced well in advance so that market participants have the necessary time to make adjustments to their positions, reducing exposure so as to avoid the need to advance more margin.

Advance warning is no more than a common courtesy to all the people who support the futures exchange and contribute to the liquidity that is the backbone of a futures market.

Late last Wednesday, Comex announced that the margin requirement on gold contracts would be increased by 50%. Not only is this quite a substantial increase, it so happens that the increase would take effect at the close of business on Thursday, less than 24 hours following the announcement.

Now there are a wide range of participants in the gold market; from their well-publicised role as regular sellers of contracts by the bullion banks to individuals who as a rule believe that the day for gold is here and who take a punt on the futures or options markets to leverage their limited capital as far as possible. In between there are the hedge funds who may well play both sides of the market, but who is said to have been predominantly buyers for some time.

The first time that small players could adjust their positions in the light of their limited capital, was when Comex opened on Thursday – except those who had already reduced their positions when spot gold fell from 6 much earlier the day to reach 6 during US trade. Hedge funds and institutions who needed to reduce exposure despite their deep pockets, could avail themselves of the after hours market. By doing so, they pre-empted any steep selling that might erupt when Come4x opened the next day and they were thus given what amounts to unfair advantage by the timing of the Comex decision.

The fact that this announcement came just after the price of gold has fallen quite steeply – thus putting a squeeze on the smaller player who is bullish about gold – is another factor that exacerbates the already uncomfortable position of the bullish individual. In fact, if one considers the time of the actual announcement, the timing in terms of the preceding and ongoing bearish move in the gold market as well as the very brief period of grace before the increase took effect, one might hazard the guess that if Comex purposefully had set out with the specific purpose to frighten the small investor out of the market, they could not have managed it better.

Now, with two days hindsight on what has happened in the futures market, it seems that if this had indeed been the objective of this gambit, Comex – or whoever else had hoped that the increase would shake the market loose into a bout of panic selling – might well be quite disappointed.

On Wednesday, open interest on Comes for all gold contracts was 245,682 contracts – the highest since the Great Gold Bull of 1981, when gold spiked above 0/oz. (Could this have been what triggered the decision to increase margin? 245,682 contracts is more than 24 million ounces of gold, or about 786 tons! Equal to a third of annual mine production. If gold kept on rising, it might be that a good number of the bulls could ask for physical delivery and with only about 67 tons in the Comex warehouse, that would have been a calamity of generous proportions!)

Now with such overexposed bullish sentiment, one would think that there would be stampede for the exits as bullish investors small and large tried to get out while the going was good. It is said that many smaller investors were in fact compelled to reduce their exposure as a consequence of the margin increase, but then other players stepped up to the plate to buy what these players were selling. This has to be so since open interest only declined by about 14 000 contracts, to leave the still very large open interest of 231 500 contracts and a spot gold price at 9 – which is a relatively insignificant below the Wednesday close.

For some time now the mantra has also been that gold is performing well under the massing clouds of war. Yet by Thursday it seemed that the clouds were receding to some degree in the wake of the Powell speech at the UN. If the mantra is correct in its assumptions, the price of gold should have fallen back much further purely in reaction to this; yet the reaction to the combined war news and the margin increase was quite muted, while the open interest tell a story of what can only be sustained bullishness on gold.

This it would seem that all this evidence – if not incontrovertible, then at least strongly circumstantial – leads to the conclusion that the gold bull run is still intact and that the likelihood of even a sustained correction could recede early this week.

If it does, it would be fascinating to speculate about the nature of the next rabbit to be hauled from the hat in an attempt to halt and reverse the trend.