You need to understand you’re playing against “the House”. Should you accidentally wind up with a winning hand, the House can change the rules. They just announce that a full house beats 4 of a kind, and you lose.
The CME/Comex just raised the margin requirements on gold futures contracts to stop the price from going up. If that doesn’t work, they’ll increase it more. When the margin gets to 100%, then they’re out of business because the “Cash” market for gold is setting the price, not the futures market.
http://www.marketwatch.com/story/cme-hikes-gold-margins-but-prices-still-rising-2011-08-10
(very unlikely, but not impossible)
This isn’t actually as bad as I make it sound. The higher the price of gold goes, the more likely there will be a very fast plunge. The exchange has to protect itself, since it guarantees that if a trader has been really stupid, they’ll jump in and pay off the loss.
“The exchange has to protect itself, since it guarantees that if a trader has been really stupid, they’ll jump in and pay off the loss.” – can I ask for a citation for that statement? I played with the Hunt Brothers years ago. They could withstand the increasing margin calls and I couldn’t. I bought before the bottom, but couldn’t maintain the margin calls through the rebound. No one – I repeat – no one guaranteed my losses. What did I miss?
You’re a retail customer, not a trader (you don’t own a seat on the CBOT/CME – asusmption). It’s the counterparty to the transaction that has the guarantee – if you can’t meet your margin call and can’t come up with the money, the person who took the other side of the futures contracts isn’t harmed by your default. I designed the electronic trading system for the CBOT called “Project A” in 1991. That’s why I know these things. I can’t speak to the changes in the last 20 years..
The exchange member who writes the contract is guaranteeing the trade to the counterparty. The guarantee I’m referring to is if the member who wrote the futures contract fails. The smaller traders work through a “clearing broker”, a larger firm that has deeper pockets – they keep the people they clear for a credit risk leash – not letting them write contracts and getting too long or short. Futures contracts have daily trading limits (or at least when I was there)…. limiting the one day move thereby limiting the one day risk. If a smaller trader got really on the wrong side and the market went limit down (or limit up) for multiple days and went belly up, the exchange seizes the “seat” owned by the trader and uses the proceeds to pay off closing out his existing contracts (hopefully).
If not, the clearning broker eats the loss as the clearing broker. In the event a major clearing broken fails, things get ugly. Part of the exchange agreement is that members agree to be assessed by the exchange to ante up the necessary funds to close out the trades…. or possibly another big firm would be paid to take over the existing broker. If the losses are so huge that so many people fail that there isn’t enough capital left to cover the open contracts, the exchange is busted and declares bankruptcy and folds and everyone is stuck. That hasn’t happened to an exchange recently, but did happen back in the “good old days”
When I was there, they came very close to failing. It happened very fast – some “wet behind the ears” whipper snapper had leased out a seat that gave him the ability to trade in treasuries – but only if he was hedging some other kind of contract. He had a brilliant plan – he would go into the treasury pit and just start buying like crazy…. the plan was that he also had options – he figured he would move the options more than he moved the futures, and the gain on the options would more than offset the loss he was going to take on the futures.
He sent the entire treasury market into a panic – rates went up something like 17/32s…. nobody was aware of any news to explain and people figured someone knew something they didn’t know and jumped in. The exchange people grabbed his ass and pulled him out of the pit…. However, his plan had a flaw – he didn’t understand the difference between a put and a call – and his futures trades were also killing the options – he ended up losing on both the options and the futures….. my memory is he was about $30 million in the hole… The seat was worth something like $100k if my memory is right. So all the seat owners had to pony up a big chunk of change so the exchange would open the next day.
Just to explain a bit more – this is related to what Tim Geithner is trying to do with the contracts like credit default swaps. When you buy or sell a futures contract, the party on the other side is the Clearing Corporation. You aren’t directly buying and selling from a specific trader. The party on the other side of the trade is not relevant to you – the Clearing Corporation is who you settle the contract with. If it wasn’t done through a central clearing firm, you would be assuming specific credit risk of the party on the other side…
Credit Default Swaps do not have a central clearing function. AIG was writing a huge quanitity of CDS’s… and Goldman was the buyer. Because the contract was directly between AIG and Goldman, Goldman was at risk if AIG failed. Part of the contract was in the event the CDS looked like the underlying CMO contract was going to default, Goldman could demand that AIG put up additional collateral. AIG got in a severe cash crunch to put up the required collateral and got to the point at which they couldn’t come up with any more money and that’s when they were siezed by the government. (On what basis, you might ask?) Had the government not taken over, AIG would have failed, and the bankrupcty receiver would have negotiated a settlement with Goldman. Goldman was already prepared to “take a haircut” and accept only a fraction of what AIG owed…. but Paulson at the Treasury and Geithner at the NY Fed (both of whom used to work for Goldman) jumped in and paid Goldman 100 cents on the dollar.
Geithner wants all derivatives to be traded as standardized contracts using a central clearing organization and with public disclosure of the trades and open interest. My sense is that misunderstands how derivative markets work and the trading will just move offshore, but I really haven’t been watching it. I only barely understand the basics of what people are doing these days.
Haha… it turns out Geithner didn’t work for Goldman after all:
http://dealbook.nytimes.com/2010/08/19/geithner-haunted-by-a-goldman-past-he-never-had/
Geithner, humff. He is part of the problem. Send his butt to Afghanistan, the dork !
Geithner is fluent in Mandarin Chinese and lived for a long time in Japan. He grew up in Thailand – he and Obama are about the same age and have very similar life stories, raised by ex-pats living outside the U.S. working for the Ford Foundation.
http://www.chicagoreader.com/chicago/busted/Content?oid=891725
There is a quite detailed explanation. The trader who was working with our group on the design was on the Board of Directors and got caller away to an emergency meeting to decide what to do. He happened to be a soybean trader – agriculture and financial products guys didn’t have a lot of overlap.