Friday, September 23, 2011

What Happened To Silver?

I suspect there will be more to this story as the weekend progresses, but the first trigger for today's fall just crossed the news wire:

The CME just increased silver margins by 16% and gold margins by 21%.

Increasing margins while an investment is already falling in price creates forced liquidations in the market.  Let me explain why: 

Most hedge fund managers are heavily leveraged in their portfolios.  That means they will borrow money to make a bet on price direction.  Let's say that the margin requirement on silver is 10%, to make the example easy to understand.  A hedge fund (or any investor) may purchase $100,000 in silver, but only have to use $10,000 in capital.  The remaining $90,000 is borrowed from the exchange.

If margin requirements are increased by 21%, that means they must now put up $2,100 in new capital to keep their silver position.  What if they don't have $2,100 available?

They must sell off some of the $100,000 of total silver purchased.  In order to now have a 12% margin they must sell off $16,000 in silver and reduce their position down to $84,000.

This is not a big deal if the price of silver is stable, but if it is already falling in price it becomes magnified.  If silver falls in value by 10%, then the investor's entire $10,000 margin (or buffer) is now gone.  Think of it like a down payment on a home.

So now the customer must come up with the 10% in margin required to keep the account open.  For the CME to raise margins during a week when silver fell by 27% causes any weak hands to have to flush their positions in order to stay alive.  It is a self re-enforcing cycle.

It is also the reason I never recommend purchasing silver or gold on margin.  As an investor you want to be able to ride through these free fall drops and purchase more if you have the opportunity to capitalize on other's misfortune.

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