Understanding any successful market is all about understanding how risk is managed in these markets. What holds true for equity and derivative markets also holds true for commodity markets. Like in equity and derivatives, commodity markets also follow a stringent risk management, surveillance and monitoring mechanism. From the trader's perspective, risk can be managed at the time of placing the orders itself. From the point of the view of the commodity exchange, margins are an important tool for managing exchange level and market level risk. Of course, exchanges also have their teams to do real-time monitoring and surveillance of trades and positions but the entire process of risk management begins with the margining system. Let us understand the order placement types and the margining system in much greater detail
Types of orders that a trader can place in the commodity markets
There are broadly 4 kinds of orders that one can place in the commodity markets. Remember, commodity trading is available on gold, silver, crude oil, zinc, pepper etc. Here are the four kinds of orders that you can place in the commodity markets
1. The most common and popular order in the commodity markets is the Day Order. This order is valid only for the date on which the order is placed. So if you place an order to buy 1 contract of gold on 16th of August, then the Day order will be valid till trading closes on the 16th of August. If the order is not executed before the end of the trading, then the order will be automatically cancelled. You do not need to manually cancel the order. The Day Order stands automatically cancelled at the end of the trading day by the system itself.
2. The second kind of an order is the Good-till-Cancelled (GTC) order. The GTC order is more popular among savvy commodity traders and hedgers who are willing to wait longer to get the price of their choice. This GTC order will be open till the time the trader placing the order actually cancels the order or the order gets automatically executed. Remember, all GTC orders will automatically stand cancelled on the expiry date. For example, the Crude Oil contract expires on 21st August 2017. On that day, all GTC orders on crude oil that are not cancelled manually or executed will stand automatically cancelled by the system on 21st August.
3. Good-Till-Date (GTD) order is a slight variant of the GTC order. The only difference is that in a GTD order, the date is specified in advance and if the order is not executed by that data then it stance automatically cancelled. A GTD order can only be placed on a date that is prior to the expiry data of that particular contract.
4. The fourth kind of an order in the commodity markets is an Immediate or Cancel (IOC) order. This is again used by savvy traders who want to make the best of a surge in price volatility so that they can get the best price either ways. The IOC order if not executed immediately at the said price and volume specification is immediately cancelled.
Understanding how the exchange manages risk through margining
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 counter parties and the exchange mechanism in general.
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