InvestorQ : Do commodity exchanges also use margins like the stock exchanges? How do they manage risk?
simran Kaur made post

Do commodity exchanges also use margins like the stock exchanges? How do they manage risk?

Mahima Roy answered.
3 years ago

As a commodity trader, one of the most basic things you need to understand the quantum of margins that you need to pay. Why do you pay margins on a commodity futures position in the first place? Remember, commodity futures are leveraged positions. That means if you can afford to buy a commodity worth Rs.5 lakhs, you are actually taking a position that is worth Rs.25 lakhs. That means in the event of any adverse movement in prices, you can incur a huge loss. It is to protect you and your commitment against a default that the margin is collected. The margin not only protects the buyer and seller from a counterparty default but also ensures that the integrity of the market mechanism is protected. Here are some of the key margins you need to know in commodities trading…

The most basic form of margining is the Position Margins (PM). These PMs are also called SPAN margins as they are based on Standard Portfolio Analysis of Risk. The PM is based on the worst case loss scenario for a client from a 2-day perspective.

SPAN margins however cover risk only under normal market risk conditions. There is something called a tail risk (extreme risk) that every commodity runs. To cover this, the exchange also imposes Extreme Loss margins on the client.

On a regular basis, there are the mark-to-market (MTM) margins that have to be deposited with the exchanges if the price movement in your commodity futures positions moves against you, irrespective of whether you are long or short.

Finally, there are two more margins that clients need to be aware of. There is the Special Margin that is imposed either on specific commodities or on the market as a whole when the exchanges see a rise in volatility. Additionally, there is also the Delivery Period Margins that are imposed by the exchange closer to the expiry to ensure that there is no default on the delivery of the commodity.

While the variety of orders gives the trader the leeway to select the order of his choice according to the need, the margins are an exchange level mechanism to protect the interest of traders, their counterparties and the exchange mechanism in general.