Commentary on Precious Metals Prepared for CoinWeek.com
By Patrick A. Heller
Precious Metals Prices are going to get more volatile starting October 1. The CME Group (NASDAQ: CME), which owns the COMEX, NYMEX, GLOBEX, and other commodity exchanges, has announced new margin rules on leveraged accounts to take effect that date in order to comply with the Dodd-Frank law.
Leveraged investments are those where the investor borrows funds, usually from the broker, in order to purchase or sell short a larger quantity of an asset than would be possible with just the funds the investor had available. The attraction of a leveraged investment is that it magnifies your profits should the market move in the investor’s favor. For instance, an investor might have $20,000 to purchase 1,000 ounces of physical silver. Instead, by the use of leverage, the investor borrows $180,000 to add to his own funds in order to purchase 10,000 ounces. If the price of silver rises by $1.00 per ounce, the investor is ahead 50% on the funds personally provided, minus the interest cost of the borrowed funds. In a leveraged short sale, the investor magnifies profits if the asset’s value drops below the purchase price.
The negative side of leveraged accounts is that when the market moves in the opposite direction of what the investor expects, losses are also magnified. Taking the example in the previous paragraph, an investor who borrowed $180,000 to add to his own $20,000 to purchase 10,000 ounces of silver would be in a loss position of $10,000 if the price of silver fell by $1.00 per ounce. Since the silver would then be only worth $190,000, a 90% leveraged position would require that the investor’s maximum loan for the investment to be $171,000. In such an instance, the investor would have to come up with another $9,000 to pay down the loan. This causes a 45% loss of original capital on just a 5% drop in the price of the asset. If the investor could not deliver funds against this margin call in the allowed time frame, the broker would close the position, returning only $11,000 to the investor minus the interest costs.
Up until October 1, CME Group has allowed investors 3-5 days to scrounge up funds to cover margin calls on leveraged holdings that are underwater. Beginning October 1, investors will only have one day to get funds to their broker.
Every time there is any kind of move in prices of investments, margin calls are triggered for some leveraged parties. Even under current rules, some investors are simply unable to come up with the funds within 3-5 days. If margin calls are not meant, the broker sells off their position. Closing the position puts even more pressure for prices to continue in the direction they were already headed.
Under the coming rule, fewer investors will be able to come up with funds in only one day. What this means is that a greater percentage of leveraged precious metals investors will be closed out of their long positions if prices fall, and that more leveraged investors will be closed out of their short positions should prices rise. Obviously, the more the price moves, the greater will be the number of margin calls hitting investors.
Don’t blame the brokers for this change that will make prices more volatile—which generally will increase the risk of loss. It was Congress and the President who enacted the Dodd-Frank Law.
My recommendation for gold and silver has always been to avoid leveraged positions. These are assets you need to own for insurance against calamities in the value of paper assets such as stocks, bonds, and currencies. Physical gold and silver may also someday save your life. Don’t risk your precious metals by using leveraged margin accounts.