Stress Tests & Variation Margin

Continuing this week's copper theme but from a different angle. Even the best trades that are printing profits left and right can carry hidden risks. I'm talking about margin, specifically variation margin.

Take a trader that bought LME priced copper and shipped it to the US to deliver against CME shorts. They locked in an arbitrage level of $1,000/mt, with landed costs of $200/mt CIF US port, netting $800/mt profit. For a refined metal trade, this profit level is virtually unheard of. Naturally most traders had been jumping all over these arb levels.

Then came yesterday's curve ball - Trump's unexpected announcement of 50% tariffs on copper. Arb levels exploded to a level of $𝟯𝟬𝟬𝟬/𝗺𝘁 CME over LME.

You might think what's the big deal? Sure, if you'd have held out booking arb you could have locked in an additional $2,000/mt profit. But you still locked in $800/mt in profit so it's nothing to be too sad about. We all know trading in hindsight is something to be avoided so what's the problem?

The problem is variation margin. If the arb levels remain at $3,000/mt, you're now carrying a negative variation margin on your arb trade of $2,000/mt until settlement. Let's say the the settlement date is September and you have a position of 5,000MT - not particularly huge considering the hundreds of thousands of tons that have moved to the US.

That's a $10 million negative margin on that single position for the next two months. Unless your company's credit line can absorb it, you would immediately face a margin call from your broker.

Margin calls must be paid in cash that business day. While your physical trade would still be making $800/mt, your company has to immediately find $10m in liquidity. Not only does the financing cost eat into profits, it puts a huge strain on cash flow.

This is by no means me saying that trades shouldn't be entered into just in case prices move against us. But it is me saying that variation margin needs to be part of the calculation. Forward planning can't just involve the front office, finance and treasury need to be fully aligned to manage this risk.

Plenty of trading firms, big and small, have failed not because their trading was bad, but because they couldn't fund the margin calls to keep trades alive.

Stress tests on futures positions are not a luxury, they are essential to ensure that no matter what happens, companies don't need to abandon profitable positions due to variation margin.