If you've paid any attention to the financial media lately, it has been hard to miss the wild ride that silver prices have been taking. Prices of the shiny precious metal have dropped like a stone in recent weeks, with iShares Silver Trust
Other commodities have been rocked, including the big one: oil. Crude oil prices have gyrated wildly in recent days, with the United States Oil ETF
Precious metals prices in particular have looked bubbly to many of us for a while now, having been on a sharp rise since inflation-wary investors started piling into them during the financial crisis of 2008. But even the most dubious investing bubbles require some impetus to pop. And in this case, the trigger might have been a surprising one: margin requirements.
An obscure trigger for a major drop
Why are margin requirements a big deal? Commodities such as silver and oil are rarely traded in physical form. Instead, investors buy and sell futures, contracts that provide for the delivery of the commodity on a set future date at a set price. Many of those buying futures are hedging, locking in prices for commodities they expect to need in the future. Think airlines buying fuel, automakers buying steel, or food producers buying wheat. Locking in prices well in advance helps companies like these plan production and manage their own expenses more carefully.
But not everyone buying or selling futures contracts intends to take delivery of the underlying commodity. Futures markets have long drawn speculators, investors who -- for instance -- think that the price of gold or oil or pork bellies (yes, really) is likely to rise and want to align their portfolios accordingly.
This is not a bad thing -- arguably, speculators help the market function properly over the long term. But because futures markets can move swiftly, CME Group
These deposits are called "margin requirements," and CME adjusts them over time based on a commodity's price and volatility. Obviously, the greater the volatility, the greater the potential one-day losses, and so the greater the deposit needed to give assurance to the CME. These adjustments aren't uncommon -- the CME has done well over 50 so far this year -- but if the requirements become particularly large, smaller traders (typically speculators) can be abruptly forced out of the market.
And that, some say, is what happened to silver: The CME announced an increase in margin requirements, and the selling started. Increased volatility in turn led to further margin increases. Likewise, oil was rocked by volatility after a similar announcement, although somewhat less dramatically.
The difference? If I had to guess, I'd say the silver market had a larger proportion of smaller speculators. Now, to be clear: Major speculators, institutions in the George Soros weight class, are unlikely to worry too much about margin requirements. It's the smaller shops and individuals who may have decided that trading these futures had become too expensive.
But what does all this mean for investors in stocks and ETFs that are affected by oil and silver prices?
Margin prices aren't the real problem with silver
In a brilliantly timed article on April 29, my Foolish colleague Alex Dumortier argued compellingly that a collapse in the price of silver was likely to happen sooner or later, and that a number of popular investments were likely to be adversely affected. While the recent drop hasn't been as large as the one Alex eventually expects, plenty of damage has been done: Investors holding shares of silver miners Coeur d'Alene Mines
Oil stocks have had a somewhat gentler ride, but it hasn't been up -- ExxonMobil
Long story short, if an exchange's routine hike in margin requirements can really trigger a 20%-plus drop in a commodity's price, that probably isn't where most of us want to be investing. If you're invested in silver (or gold), spend a few minutes reading Alex's article with an open mind. Then, if you're still interested in investing in commodities, take a look at Fool Dan Dzombak's thoughts on the best way to invest in commodities and the right commodity to buy now -- thoughts I heartily second.
Fool contributor John Rosevear has no position in the companies or ETFs mentioned. The Fool owns shares of ExxonMobil. You can try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.