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How To Buy Gold Options
By Cory Mitchell
Buy gold options to attain a position in gold for less capital than buying physical gold or gold futures. Gold options are available in the U.S. through the Chicago Mercantile Exchange (CME), so if you’ve wondered how to invest in gold, here’s a shorter-term and less capital intensive way to do it.
How to Invest in Gold: Calls and Puts
Use options to profit whether gold prices rise or fall. Believe the price of gold will rise? Buy a gold call option. A call option gives the right, but not the obligation, to buy gold at a specific price for a certain amount of time (expiry). The price you can buy gold at is called the strike price. If the price of gold rises above your strike price before the option expires, you make a profit. If the price of gold is below your strike price at expiry, you lose what you paid for the option, called the premium. (For more on how to decide which call or put option to use, see “Which Vertical Option Spread Should You Use?”)
Put options give the right, but not the obligation, to sell gold at a specific price (strike price) for a certain amount of time. If the price of gold falls below the strike price, you reap a profit of the difference between the strike price and current gold price (approximately). If the price of gold is above your strike price at expiry, your option is worthless and you lose the premium you paid for the option.
It is not necessary to hold your option till expiry. Sell it at any time to lock in a profit or minimize a loss.
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Gold Options Specifications
Gold options are cleared through the CME, trading under the symbol OG. The value of the options is tied to the price of gold futures, which also trade on the CME. 40 strike prices are offered, in $5 increments above the below the the current gold price. The further the strike price from the current gold price, the cheaper the premium paid for the option, but the less chance there is that the option will be profitable before expiry. There are more than 20 expiry times to choose from, ranging from short-term to long-term.
Each option contract controls 100 ounces of gold. If the cost of an option is $12, then the amount paid for the option is $12 x 100 = $1200. Buying a gold futures contract which controls 100 ounces requires $7,150 in initial margin. Buying physical gold requires the full cash outlay for each ounce purchased.
To buy gold options traders need a margin brokerage account which allows trading in futures and options, provided by Interactive Brokers, TD Ameritrade and others.
Gold options prices and volume data are found in the Quotes section of the CME website, or through the trading platform provided by an options broker.
The Bottom Line
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Calls and puts allow traders a less capital intensive way to profit from gold uptrends or downtrends respectively. If the option expires worthless, the amount paid (premium) for the option is lost; risk is limited to this cost. Trading gold options requires a margin brokerage account with access to options.
The Beginner’s Guide to Investing in Gold
Here’s everything you need to know about how to invest in this precious metal.
Imagine yourself sitting in a stream swirling water in a pan, desperately hoping to see a small yellow glint of gold and dreaming of striking it rich. America has come a long way since the early 1850s, but gold still holds a prominent place in our global economy today. Here’s a comprehensive introduction to gold, from why it’s valuable and how we obtain it to how to invest in it, the risks and benefits of each approach, and advice on where beginners should start.
Why is gold valuable?
In ancient times, gold’s malleability and luster led to its use in jewelry and early coins. It was also hard to dig gold out of the ground — and the more difficult something is to obtain, the higher it is valued.
Over time, humans began using the precious metal as a way to facilitate trade and accumulate and store wealth. In fact, early paper currencies were generally backed by gold, with every printed bill corresponding to an amount of gold held in a vault somewhere for which it could, technically, be exchanged (this rarely happened). This approach to paper money lasted well into the 20th century. Nowadays, modern currencies are largely fiat currencies, so the link between gold and paper money has long been broken. However, people still love the yellow metal.
Where does demand for gold come from?
The largest demand industry by far is jewelry, which accounts for around 50% of gold demand. Another 40% comes from direct physical investment in gold, including that used to create coins, bullion, medals, and gold bars. (Bullion is a gold bar or coin stamped with the amount of gold it contains and the gold’s purity. It is different than numismatic coins, collectibles that trade based on demand for the specific type of coin rather than its gold content.)
Investors in physical gold include individuals, central banks, and, more recently, exchange-traded funds that purchase gold on behalf of others. Gold is often viewed as a “safe-haven” investment. If paper money were to suddenly become worthless, the world would have to fall back on something of value to facilitate trade. This is one of the reasons that investors tend to push up the price of gold when financial markets are volatile.
Since gold is a good conductor of electricity, the remaining demand for gold comes from industry, for use in things such as dentistry, heat shields, and tech gadgets.
How is the price of gold determined?
Gold is a commodity that trades based on supply and demand. The interplay between supply and demand ultimately determines what the spot price of gold is at any given time.
The demand for jewelry is fairly constant, though economic downturns do, obviously, lead to some temporary reductions in demand from this industry. The demand from investors, including central banks, however, tends to inversely track the economy and investor sentiment. When investors are worried about the economy, they often buy gold, and based on the increase in demand, push its price higher. You can keep track of gold’s ups and downs at the website of the World Gold Council, an industry trade group backed by some of the largest gold miners in the world.
How much gold is there?
Gold is actually quite plentiful in nature but is difficult to extract. For example, seawater contains gold — but in such small quantities it would cost more to extract than the gold would be worth. So there is a big difference between the availability of gold and how much gold there is in the world. The World Gold Council estimates that there are about 190,000 metric tons of gold above ground being used today and roughly 54,000 metric tons of gold that can be economically extracted from the Earth using current technology. Advances in extraction methods or materially higher gold prices could shift that number. Gold has been discovered near undersea thermal vents in quantities that suggest it might be worth extracting if prices rose high enough.
Image source: Getty Images.
How do we get gold?
Although panning for gold was a common practice during the California Gold Rush, nowadays it is mined from the ground. While gold can be found by itself, it’s far more commonly found along with other metals, including silver and copper. Thus, a miner may actually produce gold as a by-product of its other mining efforts.
Miners begin by finding a place where they believe gold is located in large enough quantities that it can be economically obtained. Then local governments and agencies have to grant the company permission to build and operate a mine. Developing a mine is a dangerous, expensive, and time-consuming process with little to no economic return until the mine is finally operational — which often takes a decade or more from start to finish.
How well does gold hold its value in a downturn?
The answer depends partly on how you invest in gold, but a quick look at gold prices relative to stock prices during the bear market of the 2007-2009 recession provides a telling example.
Between Nov. 30, 2007, and June 1, 2009, the S&P 500 index fell 36%. The price of gold, on the other hand, rose 25%. This is the most recent example of a material and prolonged stock downturn, but it’s also a particularly dramatic one because, at the time, there were very real concerns about the viability of the global financial system.
When capital markets are in turmoil, gold often performs relatively well as investors seek out safe-haven investments.
Ways to invest in gold
Here are all the ways you can invest in gold, from owning the actual metal to investing in companies that finance gold miners.
|Gold mining stocks||
|Gold mining-focused mutual funds and ETFs||
|Streaming and royalty
The markups in the jewelry industry make this a bad option for investing in gold. Once you’ve bought it, its resale value is likely to fall materially. This also assumes you’re talking about gold jewelry of at least 10 karat. (Pure gold is 24 karat.) Extremely expensive jewelry may hold its value, but more because it is a collector’s item than because of its gold content.
Bullion, bars, and coins
These are the best option for owning physical gold. However, there are markups to consider. The money it takes to turn raw gold into a coin is often passed on to the end customer. Also, most coin dealers will add a markup to their prices to compensate them for acting as middlemen. Perhaps the best option for most investors looking to own physical gold is to buy gold bullion directly from the U.S. Mint, so you know you are dealing with a reputable dealer.
Then you have to store the gold you’ve purchased. That could mean renting a safe deposit box from the local bank, where you could end up paying an ongoing cost for storage. Selling, meanwhile, can be difficult since you have to bring your gold to a dealer, who may offer you a price that’s below the current spot price.
Another way to get direct exposure to gold without physically owning it, gold certificates are notes issued by a company that owns gold. These notes are usually for unallocated gold, meaning there’s no specific gold associated with the certificate, but the company says it has enough to back all outstanding certificates. You can buy allocated gold certificates, but the costs are higher. The big problem here is that the certificates are really only as good as the company backing them, sort of like banks before FDIC insurance was created. This is why one of the most desirable options for gold certificates is the Perth Mint, which is backed by the government of Western Australia. That said, if you’re going to simply buy a paper representation of gold, you might want to consider exchange-traded funds instead.
If you don’t particularly care about holding the gold you own but want direct exposure to the metal, then an exchange-traded fund (ETF) like SPDR Gold Shares is probably the way to go. This fund directly purchases gold on behalf of its shareholders. You’ll likely have to pay a commission to trade an ETF, and there will be a management fee (SPDR Gold Share’s expense ratio is 0.40%), but you’ll benefit from a liquid asset that invests directly in gold coins, bullion, and bars.
Another way to own gold indirectly, futures contracts are a highly leveraged and risky choice that is inappropriate for beginners. Even experienced investors should think twice here. Essentially, a futures contract is an agreement between a buyer and a seller to exchange a specified amount of gold at a specified future date and price. As gold prices move up and down, the value of the contract fluctuates, with the accounts of the seller and buyer adjusted accordingly. Futures contracts are generally traded on exchanges, so you’d need to talk to your broker to see if it supports them.
The biggest problem: Futures contracts are usually bought with only a small fraction of the total contract cost. For example, an investor might only have to put down 20% of the full cost of the gold controlled by the contract. This creates leverage, which increases an investor’s potential gains — and losses. And since contracts have specific end dates, you can’t simply hold on to a losing position and hope it rebounds. Futures contracts are a complex and time-consuming investment that can materially amplify gains and losses. Although they are an option, they are high-risk and not recommended for beginners.
Gold mining stocks
One major issue with a direct investment in gold is that there’s no growth potential. An ounce of gold today will be the same ounce of gold 100 years from now. That’s one of the key reasons famed investor Warren Buffett doesn’t like gold — it is, essentially, an unproductive asset.
This is why some investors turn to mining stocks. Their prices tend to follow the prices of the commodities on which they focus; however, because miners are running businesses that can expand over time, investors can benefit from increasing production. This can provide upside that owning physical gold never will.
However, running a business also comes with the accompanying risks. Mines don’t always produce as much gold as expected, workers sometimes go on strike, and disasters like a mine collapse or deadly gas leak can halt production and even cost lives. All in all, gold miners can perform better or worse than gold — depending on what’s going on at that particular miner.
In addition, most gold miners produce more than just gold. That’s a function of the way gold is found in nature, as well as diversification decisions on the part of the mining company’s management. If you’re looking for a diversified investment in precious and semiprecious metals, then a miner that produces more than just gold could be seen as a net positive. However, if what you really want is pure gold exposure, every ounce of a different metal that a miner pulls from the ground simply dilutes your gold exposure.
Potential investors should pay close attention to a company’s mining costs, existing mine portfolio, and expansion opportunities at both existing and new assets when deciding on which gold mining stocks to buy.
If you’re looking for a single investment that provides broadly diversified exposure to gold miners, then low-cost index-based ETFs like VanEck Vectors Gold Miners ETF and VanEck Vectors Junior Gold Miners ETF are a good option. Both also have exposure to other metals, but the latter focuses on smaller miners; their expense ratios are 0.53% and 0.54%, respectively.
As you research gold ETFs, look closely at the index being tracked, paying particular attention to how it is constructed, the weighting approach, and when and how it gets rebalanced. All are important pieces of information that are easy to overlook when you assume that a simple ETF name will translate into a simple investment approach.
Investors who prefer the idea of owning mining stocks over direct gold exposure can effectively own a portfolio of miners by investing in a mutual fund. This saves the legwork of researching the various mining options and is a simple way to create a diversified portfolio of mining stocks with a single investment. There are a lot of options here, with most major mutual fund houses offering open-end funds that invest in gold miners, such as the Fidelity Select Gold Portfolio and Vanguard Precious Metals Fund.
However, as the Vanguard fund’s name implies, you are likely to find a fund’s portfolio contains exposure to miners that deal with precious, semiprecious, and base metals other than gold. That’s not materially different from owning mining stocks directly, but you should keep this factor in mind, because not all fund names make this clear. (For example, the Fidelity Select Gold Portfolio also invests in companies that mine silver and other precious metals.)
Fees for actively managed funds, meanwhile, can be materially higher than those of index-based products. You’ll want to read a fund’s prospectus to get a better handle on its investing approach, whether it is actively managed or a passive index fund, and its cost structure. Note that expense ratios can vary greatly between funds.
Also, when you buy shares of an actively managed mutual fund, you are trusting that the fund managers can invest profitably on your behalf. That doesn’t always work out as planned.
Streaming and royalty companies
For most investors, buying stock in a streaming and royalty company is probably the best all-around option for investing in gold. These companies provide miners with cash up front for the right to buy gold and other metals from specific mines at reduced rates in the future. They are like specialty finance companies that get paid in gold, allowing them to avoid many of the headaches and risks associated with running a mine.
Benefits of such companies includes widely diversified portfolios, contractually built-in low prices that lead to wide margins in good years and bad, and exposure to gold price changes (since streaming companies make money by selling the gold they buy from the miners). That said, none of the major streaming companies has a pure gold portfolio, with silver the most common added exposure. (Franco-Nevada, the largest streaming and royalty company, also has exposure to oil and gas drilling.) So you’ll need to do a little homework to fully understand what commodity exposures you’ll get from your investment. And while streaming companies avoid many of the risks of running a mine, they don’t completely sidestep them: If a mine isn’t producing any gold, there’s nothing for a streaming company to buy.
The built-in wide margins that result from the streaming approach provide an important buffer for these businesses. That has allowed the profitability of streamers to hold up better than miners’ when gold prices are falling. This is the key factor that gives streaming companies an edge as an investment. They provide exposure to gold, they offer growth potential via the investment in new mines, and their wide margins through the cycle provide some downside protection when gold prices fall. That combination is hard to beat.
What’s the best way for a beginner to invest in gold?
There’s no perfect way to own gold: Each option comes with trade-offs. That said, probably the best strategy for most people is to buy stock in streaming and royalty companies. However, what to invest in is just one piece of the puzzle: There are other factors that you need to consider.
How much should you invest in gold?
Gold can be a volatile investment, so you shouldn’t put a large amount of your assets into it — it’s best to keep it to less than 10% of your overall stock portfolio. The real benefit, for new and experienced investors alike, comes from the diversification that gold can offer. Once you’ve built your gold position, make sure to periodically balance your portfolio so that your relative exposure to it remains the same.
When should you buy gold?
It’s best to buy small amounts over time. When gold prices are high, the price of gold-related stocks rises as well. That can mean lackluster returns in the near term, but it doesn’t diminish the benefit over the long term of holding gold to diversify your portfolio. By buying a little at a time, you can dollar-cost average into the position.
As with any investment, there’s no one-size-fits-all answer for how you should invest in gold. But armed with the knowledge of how the gold industry works, what each type of investment entails, and what to consider when weighing your options, you can make the decision that’s right for you.
Put Options Under The Spotlight: When They’re A Safe Bet [And The Dangers Of Expiring Worthless]
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Last Updated on May 18, 2020
Buying put options is a bearish strategy using leverage and is a risk-defined alternative to shorting stock. An illustration of the thought process of buying a put is given next:
- A trader is very bearish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply shorting stock.
- The trader expects the stock to move below $47.06 in the next 30 days.
Given those expectations, the trader selects the $47.50 put option strike price which is trading for $0.44. For this example, the trader will buy only 1 put option contract (Note: 1 contract is for 100 shares) so the total cost will be $44 ($0.44 x 100 shares/contract). The graph below of this hypothetical situation is given below:
There are numerous reasons, both technical and fundamental, why a trader could feel bearish.
Options Offer Defined Risk
When a put option is purchased, the trader instantly knows the maximum amount of money they can possibly lose. The max loss is always the premium paid to own the option contract; in this example, $44. Whether the stock rises to $55 or $100 a share, the put option holder will only lose the amount they paid for the option. This is the risk-defined benefit often discussed about as a reason to trade options.
Options offer Leverage
The other benefit is leverage. When a stock price is below its breakeven point (in this example, $47.06) the option contract at expiration acts exactly like being short stock. To illustrate, if a 100 shares of stock moves down $1, then the trader would profit $100 ($1 x $100). Likewise, below $47.06, the options breakeven point, if the stock moved down $1, then the option contract would increase by $1, thus making $100 ($1 x $100) as well.
Remember, to short the stock, the trader would have had to put up margin requirements, sometimes 150% of the present stock value ($7,500). However, the trader in this example, only paid $60 for the put option and does not need to worry about margin calls or the unlimited risk to the upside.
Options require Timing
The important part about selecting an option and option strike price, is the trader’s exact expectations for the future. If the trader expects the stock to move lower, but only $1 lower, then buying the $47.50 strike price would be foolish. This is because at expiration, if the stock price is anywhere above $47.50, whether it be $75 or $47.51, the put option will expire worthless. If a trader was correct on their prediction that the stock would move lower by $1, they would still have lost.
Similarly, if the stock moved down to $46 the day after the put option expired, the trader still would have lost all their premium paid for the option. Simply stated, when buying options, you need to predict the correct direction of stock movement, the size of the stock movement, and the time period the stock movement will occur–more complicated then shorting stock, when all a person is doing is predicting that the stock will move in their predicted direction downward.
Put Options Profit, Loss, Breakeven
The following is the profit/loss graph at expiration for the put option in the example given on the previous page.
The breakeven point is quite easy to calculate for a put option:
- Breakeven Stock Price = Put Option Strike Price – Premium Paid
To illustrate, the trader purchased the $47.50 strike price put option for $0.44. Therefore, $47.50 – $0.44 = $47.06. The trader will breakeven, excluding commissions/slippage, if the stock falls to $47.06 by expiration.
To calculate profits or losses on a put option use the following simple formula:
- Put Option Profit/Loss = Breakeven Point – Stock Price at Expiration
For every dollar the stock price falls once the $47.06 breakeven barrier has been surpassed, there is a dollar for dollar profit for the options contract. So if the stock falls $5.00 to $45.00 by expiration, the owner of the the put option would make $2.06 per share ($47.06 breakeven stock price – $45.00 stock price at expiration). So total, the trader would have made $206 ($2.06 x 100 shares/contract).
If the stock price decreased by $2.75 to close at $47.25 by expiration, the option trader would lose money. For this example, the trader would have lost $0.19 per contract ($47.06 breakeven stock price – $47.25 stock price). Therefore, the hypothetical trader would have lost $19 (-$0.19 x 100 shares/contract).
To summarize, in this partial loss example, the option trader bought a put option because they thought that the stock was going to fall. By all accounts, the trader was right, the stock did fall by $2.75, however, the trader was not right enough. The stock needed to move lower by at least $2.94 to $47.06 to breakeven.
If the stock did not move lower than the strike price of the put option contract by expiration, the option trader would lose their entire premium paid $0.44. Likewise, if the stock moved up, irrelavent by how much it moved upward, then the option trader would still lose the $0.44 paid for the option. In either of those two circumstances, the trader would have lost $44 (-$0.44 x 100 shares/contract).
Again, this is where the limited risk part of option buying comes in: the stock could have risen 20 points, potentially blowing out a trader shorting the stock, but the option contract owner would still only lose their premium paid, in this case $0.44.
Buying put options has many positive benefits like defined-risk and leverage, but like everything else, it has its downside, which is explored on the next page.
Downside of Buying Put Options
Take another look at the put option profit/loss graph. This time, think about how far away from the current stock price of $50, the breakeven price of $47.06 is.
Put Options need Big Moves to be Profitable
Putting percentages to the breakeven number, breakeven is a 5.9% move downward in only 30 days. That sized movement is realistically possible, but highly unlikely in only 30 days. Plus, the stock has to move down more than the 5.9% to even start to make a cent of profit, profit being the whole purpose of entering into a trade. To begin with, a comparison of shorting 100 shares and buying 1 put option contract ($47.50 strike price) will be given:
- 100 shares: $50 x 100 shares = $7,500 margin deposit ($5,000 received for sold shares + 50% of the $5,000 as additional margin)
- 1 call option: $0.44 x 100 shares/contract = $44; keeps the rest ($7,456) in savings.
If the stock moves down 2% in the next 30 days, the shortseller makes $100; the call option holder loses $44:
- Shortseller: Gains $100 or 1.3%
- Option Holder: Loses $44 or 0.6% of total capital
If the stock moves down 5% in the following 30 days:
- Shortseller: Gains $250 or 3.3%
- Option Holder: Loses $44 or 0.6%
If the stock moves down 8% over the next 30 days, the option holder finally begins to make money:
- Shortseller: Gains $400 or 5.3%
- Option Holder: Gains $106 or 1.4%
It’s fair to say, that buying these out-of-the money (OTM) put options and hoping for a larger than 5.9% move lower in the stock is going to result in numerous times when the trader’s call options will expire worthless. However, the benefit of buying put options to preserve capital does have merit.
Substantial losses can be incredibly devastating. For an extreme example, a 50% loss means a trader has to make 100% profit on their next trade in order to breakeven. Also, it is important to emphasize that shorting stock is very risky, since, theoretically, stocks can increase to infinity. This means shorting stock has unlimited risk to the upside.
Buying put options and continuing the prior examples, a trader is only risking a small 0.6% of capital for each trade. This prevents the trader from incurring a single substantial loss, which is a real reality when stock trading. For example, a simple small loss from a 5% move higher is easier to take for an option put holder than a shortseller:
- Shortseller: Loses $250 or 3.3%
- Option Holder: Loses $44 or 0.6%
For a catastrophic 20% move higher in the stock, things get much worse for the shortseller:
- Shortseller: Loses $1,000 or 13.3%
- Option Holder: Loses $44 or 0.6%
In the case of the 20% stock move higher, the option holder can strike out for over 22 months and still not lose as much as the shortseller.
Moral of the story
Options are tools offering the benefits of leverage and defined risk. But like all tools, they are best used in specialized circumstances. Options require a trader to take into consideration:
- The direction the stock will move.
- How much the stock will move
- The time frame the stock will make its move
A future is simply a deal to trade gold at terms (i.e. amounts and prices) decided now, but with a settlement day in the future. That means you don’t have to pay up just yet (at least not in full) and the seller doesn’t need to deliver you any gold just yet either. It’s as easy as that.
The settlement day is the day when the actual exchange takes place – i.e. when the buyer pays, and the seller delivers the gold. It’s usually up to 3 months ahead.
Most futures traders use the delay to enable them to speculate – both ways. Their intention is to sell anything they have bought, or to buy back anything they have sold, before reaching the settlement day. Then they will only have to settle their gains and losses. In this way they can trade in much larger amounts, and take bigger risks for bigger rewards, than they would be able to if they had to settle their trades as soon as dealt.
Gold Futures & Margin
Delaying the settlement creates the need for margin, which is one of the most important aspects of buying (or selling) a gold future.
Margin is required because delaying settlement makes the seller nervous that if the gold price falls the buyer will walk away from the deal which has been struck, while at the same time the buyer is nervous that if the gold price rises the seller will similarly walk away.
Margin is the downpayment usually lodged with an independent central clearer which protects the other party from your temptation to walk away. So if you deal gold futures you will be asked to pay margin, and depending on current market conditions it might be anything from 2% to 20% of the total value of what you dealt.
Topping up the Margin
If you have bought and the gold price starts falling you will be obliged to pay more margin.
As a buyer you cannot get out of paying margin calls in a falling market until you sell, which is why buying futures sometimes costs people very much more than they originally invested.
Now you can see how futures provide leverage, sometimes known as gearing.
For example, suppose you had $5,000 to invest. If you buy gold bullion and settle you can only buy $5,000 worth. But you can probably buy $100,000 of gold futures! That’s because your margin on a $100,000 future will probably be about 5% – i.e. $5,000.
If the underlying price goes up 10% you would make $500 from bullion, but $10,000 from gold futures.
Sounds good, but don’t forget the flip side. If the price of gold falls 10% you’ll lose just $500 with bullion, and your investment will be intact to earn you money if gold resumes its steady upwards trend.
But the same 10% fall will cost you $10,000 with futures, which is $5,000 more than you invested in the first place. You will probably have been persuaded to deposit the extra $5,000 as a margin top-up, and the pain of a $10,000 loss will force you to close your position, so your money is lost.
If you refused to top-up your margin you will be closed out by your broker, and your original $5,000 will be lost on a minor intra-day adjustment – a downwards blip in the long-term upward trend in gold prices.
You can see why futures are dangerous for people who get carried away with their own certainties. The large majority of people who trade futures lose their money. That’s a fact. They lose even when they are right in the medium term, because futures are fatal to your wealth on an unpredicted and temporary price blip.
Gold Futures ‘On-Exchange’
Big professional traders invent the contractual terms of their futures trading on an ad-hoc basis and trade directly with each other. This is called ‘Over The Counter’ trading (or OTC for short).
Fortunately you would be spared the pain (and the mathematics) of detailed negotiations because you will almost certainly trade a standardized futures contract on a financial futures exchange.
In a standardized contract the exchange itself decides the settlement date, the contract amount, the delivery conditions etc. You can make up the size of your overall investment buy buying several of these standard contracts.
Dealing standard contracts on a financial futures exchange will give you two big advantages:-
- Firstly there will be deeper liquidity than with an OTC future – enabling you to sell your future when you like, and to anybody else. That is not usually possible with an OTC future.
- Secondly there will be a central clearer who will guarantee the trade against default. The central clearer is responsible (among other things) for looking after margin calculations and collecting and holding the margin for both the buyer and the seller.
Note that gold futures are dated instruments which cease trading before their declared settlement date.
At the time trading stops most private traders will have sold their longs or bought back their shorts. There will be a few left who deliberately run the contract to settlement – and actually want to make or take delivery of the whole amount of gold they bought.
On a successful financial futures exchange those running the contract to settlement will be a small minority. The majority will be speculators looking to profit from price moves, without any expectation of getting involved on bullion settlements.
The suspension of dealing a few days before settlement day allows the positions to be sorted out and reconciled such that the people still holding the ‘longs’ can arrange to pay in full and the people holding the ‘shorts’ can arrange supply of the full amount of the gold sold.
Some futures brokers refuse to run customer positions to settlement. Lacking the facilities to handle good delivery gold bullion they will require their investors to close out their positions, and – should they want to retain their position in gold – re-invest in a new futures contract for the next available standardised settlement date.
These rollovers are expensive. As a rule of thumb if your gold position is likely to be held for more than three months (i.e. more than one rollover) it is cheaper to buy bullion than to buy futures.
Dealing Gold Futures
To deal gold futures you need to find yourself a futures broker. The futures broker will be a member of a futures exchange. The broker will manage your relationship with the market, and contact you on behalf of the central clearer to – for example – collect margin from you.
Your broker will require you to sign a detailed document explaining that you accept the significant risks of futures trading.
Account set-up will take a few days, as the broker checks out your identity and creditworthiness.
Hidden Financing Costs
It sometimes appears to unsophisticated investors (and to futures salesmen) that buying gold futures saves you the cost of financing a gold purchase, because you only have to fund the margin – not the whole purchase. This is not true.
It is vital you understand the mechanics of futures price calculations, because if you don’t it will forever be a mystery for you where your money goes.
The spot gold price is the gold price for immediate settlement. It is the reference price for gold all over the world.
A gold futures contract will almost always be priced at a different level to spot gold. The differential closely tracks the cost of financing the equivalent purchase in the spot market.
Because both gold and cash can be lent (and borrowed) the relationship between the futures and the spot price is a simple arithmetical one which can be understood as follows:
“My future purchase of gold for dollars delays me having to pay a known quantity of dollars for a known quantity of gold. I can therefore deposit my dollars until settlement time, but I cannot deposit the gold – which I haven’t received yet. Since dollars in the period will earn me 1%, and gold will only earn the seller who’s holding on to it for me 0.25%, I should expect to pay over the spot price by the difference 0.75%. If I didn’t pay this extra the seller would just sell his gold for dollars now, and deposit the dollars himself, keeping an extra 0.75% overall. Clearly this 0.75% will fall out of the futures price day by day, and this represents the cost of financing the whole purchase, even though I only actually put down the margin.”
You will notice that so long as dollar interest rates are higher than gold lease rates then – because of this arithmetic – the futures price will be above the spot price. There’s a special word for this which is that the futures are in ‘contango’. What it means is that a futures trade is always in a steady uphill struggle to profit. For you to profit the underlying gold commodity must rise at a rate faster than the contango falls to zero – which will be at the expiry of the future.
Note: If dollar interest rates drop below the gold lease rates the futures price will be below the spot price. Then the market is said to be in ‘backwardation’.
Many futures broking firms offer investors a stop loss facility. It might come in a guaranteed form or on a ‘best endeavours’ basis without the guarantee. The idea is to attempt to limit the damage of a trading position which is going bad.
The theory of a stop loss seems reasonable, but the practice can be painful. The problem is that just as trading in this way can prevent a big loss it can also make the investor susceptible to large numbers of smaller and unnecessary losses which are even more damaging in the long term.
On a quiet day market professionals will start to move their prices just to create a little action. It works. The trader marks his price rapidly lower, for no good reason. If there are any stop losses out there this forces a broker to react to the moving price by closing off his investor’s position under a stop loss agreement.
In other words the trader’s markdown can force out a seller. The opportunist trader therefore picks up stop loss stock for a cheap price and immediately marks the price up to try and ‘touch off’ another stop loss on the buy side as well. If it works well he can simulate volatility on an otherwise dull day, and panic the stop losses out of the market on both sides, netting a tidy profit for himself.
It should be noted that the broker gets commission too, and what’s more the broker benefits by being able to control his risk better if he can shut down customers’ problem positions unilaterally. Brokers in general would prefer to stop loss than to be open on risk for a margin call for 24 hours.
Only the investor loses, and by the time he knows about his ‘stopped loss’ the market – as often as not – is back to the safe middle ground and his money is gone.
Without wishing to slur anyone in particular the stop-loss is even more dangerous in an integrated house – where a broker can benefit himself and his in-house dealer by providing information about levels where stop-losses could be triggered. This is not to say anyone is doing it, but it would probably be the first time in history that such a conflict of interest did not attract a couple of unscrupulous individuals somewhere within the industry.
Investors can prevent being stopped out by resisting the temptation to have too big a position just because the futures market lets them. If the investment amount is lower and plenty of surplus margin cover is down, a stop loss is unnecessary and the broker’s pressure to enter a stop loss order can be resisted.
A conservative investment strategy with smaller positions achieves the goal of avoiding catastrophic losses by not keeping all eggs in one basket. It also avoids being steadily stripped by stop loss executions. On the flip side you cannot get rich quickly with a conservative investment strategy (but then the chances of that were pretty small anyway).
Gold Futures Rollover
There is an acute psychological pressure involved in owning gold futures for a long time.
As a futures contract ends – usually every quarter – an investor who wants to keep the position open must re-contract in the new period by ‘rolling-over’. This ‘roll-over’ has a marked psychological effect on most investors.
Having taken the relatively difficult step of taking a position in gold futures investors are required to make repeated decisions to spend money. There is no ‘do nothing’ option, like there is with a bullion investment, and rolling over requires the investor to pay-up, while simultaneously giving the opportunity to cut and run.
The harsh fact of life is that if investors are being whip-lashed by the regular volatility which appears at the death of a futures contract many of them will cut their losses. Alternatively they might attempt to trade cleverly into the next period, or decide to take a breather from the action for a few days (‘though days frequently turn into weeks and months). Unfortunately every quarter lots of investors will fail the psychological examination and close their position. Many will not return. The futures markets tend to expel people at the time of maximum personal disadvantage.
Each quarter a futures investor receives an inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced rate. To those who do not know the short term money rates and the relevant gold lease rates – or how to convert them into the correct differential for the two contracts – the price is fairly arbitrary and not always very competitive.
It can be checked – but only at some effort. Suppose that gold can be borrowed for 0.003% per day (1.095% per annum) and cash for 0.01% per day (3.65% per annum). The fair value for the next quarter’s future should be 90 days times the daily interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63% to the spot price. This is where you pay the financing cost on the whole size of your deal.
Running To Settlement
The professionals often aim to settle – a luxury not always available to the private investor.
A big futures player can probably arrange a short term borrowing facility for 4% and borrow gold for 1%, whereas a private investor cannot borrow gold and might pay 12%-15% for money which prices settlement out of his reach, even if he had the storage facility and other infrastructure in place to take delivery.
Beware of this imbalance. The big players can apply pressure at the close of a futures contract, and the small private player can do little about it. This does not happen to bullion owners.
Futures markets have structural features which are not natural in markets.
In normal markets a falling price encourages buyers who pressure the price up, and a rising price encourages sellers who pressure the price down. This is relatively stable. But successful futures exchanges offer low margin percentages (of about 2% for gold) and to compensate for this apparent risk the exchange’s member firms must reserve the right to close out their losing customers.
In other words a rapidly falling market can force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price, and either scenario has the potential to produce a runaway spiral. This is manageable for extremely long periods of time, but it is an inherent danger of the futures set-up.
It was virtually the same phenomenon which was paralleled in 1929 by brokers loans. The forced selling which these encouraged as markets started to fall was at the heart of the subsequent financial disaster. In benign times this structure merely encourages volatility. In less benign times it can lead to structural failure.
Risk of Systemic Failure
Gold is bought as the ultimate defensive investment. Many people buying gold hope to make large profits from a global economic shock which might be disastrous to many other people. Indeed many gold investors fear financial meltdown occurring as a result of the over-extended global credit base – a significant part of which is derivatives.
The paradox in investing in gold futures is that a future is itself a ‘derivative’ instrument constructed on about 95% pure credit. There are many speculators involved in the commodities market and any rapid movement in the gold price is likely to be reflecting financial carnage somewhere else.
Both the clearer and the exchange could theoretically find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous book profits which could not be paid as busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses.
This sounds like panic-mongering, but it is an important commercial consideration. It is inevitable that the commodity exchange which comes to dominate through good times and healthy markets will be the one which offers the most competitive margin (credit) terms to brokers. To be attractive the brokers must pass on this generosity to their customers – i.e. by extending generous trading multiples over deposited margin. So the level of credit extended in a futures market will tend to the maximum which has been safe in the recent past, and any exchange which set itself up more cautiously will have already withered and died.
The futures exchanges we see around us today are those whose appetite for risk has most accurately trodden the fine line between aggressive risk taking and occasional appropriate caution. There is no guarantee that the next management step will not be just a bit too brave.
Gold Futures – Summary
Succeeding in the futures market is not easy. To be successful you need strong nerves and sound judgement. Investors should recognise that futures are at their best for market professionals and short term speculations in anticipation of big moves, which diminsh the effects of contango and rollover costs.
The investor should understand that there are problems when a market loses its transparency. Once a market can apply costs which are opaque and difficult to comprehend – and surely the futures market qualifies in this regard – the advantage shifts to professionals who are sophisticated enough to see through the fog.
Many individuals who have tried their luck in this market have been surprised at the speed at which their money has gone.
Please Note: This analysis is published to inform your thinking, not lead it. Previous price trends are no guarantee of future performance. Before investing in any asset, you should seek financial advice if unsure about its suitability to your personal circumstances.
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