Gold Futures Market
A gold future is a contract between a seller and a buyer to trade a certain amount of gold at a predetermined price at some point in the future. The date of the exchange, also known as the settlement day, could be set up to three months ahead. On the settlement day, the seller must deliver the agreed amount of gold and the buyer must pay for the gold in full.
The extra time after the agreement takes place and before the terms of the settlement, the day allows futures traders to speculate. If they can sell everything they have bought or buy everything they have sold, then the traders need only to settle their gains and losses. Having some time before settlement makes it possible for traders to trade much larger amounts and take bigger risks, both of which promise bigger rewards on the exchange market.
Gold Futures and Margin
Margin is one of the fundamental features of trading gold futures. The delayed settlement day makes the margin possible.
Margin is a necessary protective measure for both parties involved in a trade. It gives peace of mind to the seller by ensuring that the buyer won't walk away in case the gold prices suddenly fall before the settlement day. Margin also reassures the buyer that the seller will deliver the gold even if the gold prices unexpectedly rise.
Margin takes the form of a down payment that the sellers and buyers must pay to an independent central clearer. The exact margin amounts depend on market conditions and could range between 2 and 20 percent of the total value of the trade.
Topping Up the Margin
You will have to pay higher margin if the gold prices go down after your purchase. This reason points to why gold futures could cost much more than the initial investment.
Gold futures can give you leverage, also known as gearing. Explore the concept of leverage with the following example.
If you have $10,000 and want to purchase gold bullion, you can only buy $10,000 worth. However, you may be able to buy $200,000 worth of gold futures, which will likely have a margin of about 5 percent (or $10,000).
If the gold price rises by 10 percent, bullion will make you $1,000, while gold futures will earn you $20,000 in profits.
As appealing as this earning maybe, don't forget about the downside of this scenario. In case the price drops by 10 percent, you will lose only $1,000 with bullion and still have $9,000 left to earn your profits once the gold prices begin to rise.
However, you will lose $20,000 with futures, which is twice as much as your original investment. If you pay an additional $10,000 as a margin top-up, your loss is $20,000 and you are likely to close your position. If you refuse to cover your margin, your broker will close your position, leaving you with a $10,000 loss. The full amount of your investment can be lost in one day due to a minor price change.
Even though gold futures provide great leverage, trading gold could be detrimental to the wealth of the individuals sensitive to fluctuations in the gold prices from day-to-day. Even though the long-term trend for gold prices is upward, temporary and unexpected price changes can cause people to lose their money.
Gold Futures 'On-Exchange'
In “over-the-counter” (OTC) trading, large professional traders devise their own contract terms for trading futures and trade with each other directly. However, many individuals trade a standardized futures contract on a financial futures exchange.
In a standardized contract, the contract terms, including the settlement date, contract amount, and delivery conditions, are determined by the exchange. Your total investment could be composed of several standard contracts.
Compared to OTC trading, trading standard contracts comes with two main advantages. Standard contracts have greater liquidity, which allows you to sell your futures anytime to anyone. Also, trading standard contracts involve a central clearer responsible for collecting and holding margin from both parties to guarantee delivery of contract terms.
Remember that gold futures are dated, and their trading stops some time before the settlement date.
When trading stops, many private traders have already sold their longs or bought back their shorts. Only a few traders will run the contract to settlement deliberately. Many traders are speculators trying to benefit from price fluctuations, and they have no intention of getting involved in bullion settlements.
The stopping of trading a few days before the settlement date gives time for the positions to make necessary arrangements either for making payments in full if they still hold the “longs" or for delivery of the full amount of the gold if they still hold the “shorts.”
Unable to handle gold bullion delivery, some futures brokers require their investors to close out their positions before settlement or reinvest in a new futures contract to retain their position in gold. However, such rollovers are costly. Buying bullion is more economical if your gold position is going to be held for more than three months.
Trading Gold Futures
To begin trading gold futures, you need a futures broker. As a member of a futures exchange, the broker will be in charge of your relationship with the market and the central clearer.
Setting up your account with the broker usually takes a few days. You will be presented with a document detailing all the risks associated with futures trading. By signing the document, you assume all the trading risks. The broker will also run your identity and credit checks.
Hidden Financing Costs
To inexperienced investors and futures sales professionals, purchasing gold futures may seem like savings for the cost of financing a gold purchase because you need only to fund the margin. This assumption is incorrect. You must understand how futures prices are calculated to know where your money goes.
The worldwide reference price for gold, the spot gold price, is the gold price for immediate settlement. Gold futures prices are usually different and reflect the cost of financing a gold purchase on the spot market. Since both gold and cash can be loaned and borrowed, the relationship between the futures and the spot price takes an arithmetic nature and can be reasoned as follows:
Since I will buy a certain amount of gold for a certain amount of dollars in the future, I can deposit this amount of dollars until the settlement day.
Since my dollars will earn me a profit of 1 percent and gold will only earn 0.25 percent for the seller, I can expect to pay 0.75 percent over the spot price. If I don't pay the difference, the seller will have no incentive to hold the gold for me. The seller will sell the gold, deposit the dollars, and keep the 0.75 percent difference, which represents the cost of financing the gold purchase. “
As long as dollar interest rates are above gold lease rates, the futures price will be higher than the spot price, indicating that the futures are in “contango.” To generate profit, gold prices must rise at a faster rate than the contango falls to zero (at future's expiration date).
If dollar interest rates are lower than the gold lease rates, the futures price is lower than the spot price. This scenario is known as market “backwardation.”
Many brokers offer investors a stop-loss service, which could be executed either every time when triggered or on a "best endeavors" basis. A stop-loss helps to decrease the damage of a bad trading position.
Although the idea of a stop-loss makes sense, its practice has some problems. While a stop-loss trading can help avoid big losses, it creates a possibility for a large number of smaller losses, which could be detrimental to the investor in the long run.
Often, market professionals will move their prices only to create some action on a quiet day. A trader, for example, could suddenly drop prices. As a result, a broker is forced to close off an investor's position according to a stop-loss agreement, if one is in place.
Ultimately, a sudden price markdown could force out a seller. An opportunistic trader will usually buy a stop-loss stock for a low price and raise the price right away to trigger stop-loss on the buyer's side. This way, the trader can simulate volatility and force the stop-losses out of the market. Meanwhile, the trader earns a good profit.
Brokers get commission and usually benefit more if they close investors' problem positions unilaterally, meaning that only the investor loses. Also, brokers are more inclined to stop-loss rather than to be open to risk even for a day. Typically, by the time the investor learns about a stopped loss, the market is back to normal, except that the investor lost money.
Stop-loss becomes even more problematic in an integrated house where a broker and his in-house trader can benefit from disclosing information about possible opportunities for triggering stop-losses.
To avoid being forced out of the market due to a stop-loss order, you could opt for smaller investment amounts. At the same time, by diversifying your investment portfolio, you can avoid losing large amounts of money. However, you should not expect quick and large profits with such a conservative investment strategy.
Gold Futures Rollover
Many owners of gold futures experience intense psychological pressure, especially during the futures expiration period. At the end of a futures contract, an investor must reinvest, or “rollover,” in the new period to maintain a position open.
Once an investor takes a position in gold futures, this individual must commit to spending money continually. Unlike gold bullion, gold futures don't tolerate idleness. At the end of the futures contract, the investor must act — either pay up and rollover or cut the losses and opt-out.
Unfortunately, many investors aren't able to handle consistent market volatility at the end of a futures contract and close out their positions for good.
Every quarter, a broker makes a call to his futures investors and offers them a special reduced price to roll over into the new futures period. This price is usually arbitrary and is rarely a competitive one. Only if the investor is well-versed in the matters of short-term interest rates, the gold lease rates, and how they can be converted into the correct differentials for the two contracts, can the investor negotiate a fair price for individual benefit?
You can check to determine whether you are getting a good rollover price from your broker. For example, the gold lease rate is 0.003 percent per day (1.095 percent per year) and the cash borrowing rate is 0.01 percent per day (3.65 percent per year). To calculate the fair price for the next period's future, multiply 90 days by 0.007 percent (the daily interest difference between cash and gold). The resulting 0.63 percent is the next future's premium to the spot price.
Running to Settlement
Usually, professional traders have a goal to settle, something which is rarely possible for private investors.
Large investors have no difficulty obtaining a short-term borrowing facility for 4 percent and borrow gold for 1 percent, while private investors cannot borrow gold even if they have appropriate facilities for delivery and storage. Thus, private investors will typically be offered 12 to 15 percent for money, which makes the settlement option unattainable for them.
Unlike bullion owners, small gold futures traders are often pressured by large investors at the end of the futures contract.
Futures markets are different from other markets and have some distinct qualities.
Typically, when a price goes down, buyers will buy more, thus causing the price to go up. An increase in prices will stimulate sellers to increase their sales inventory, which will bring the prices down. This arrangement is how the market maintains its balance.
In futures markets, due to small margins and high risk, exchange firms have the right to close out losing customers. When the futures market falls quickly, sales are encouraged, and the prices keep going down. When prices rise quickly, this rise stimulates buying and a further increase in prices. In both cases, a runaway spiral has a chance to develop. Although such a setup simulates volatility during normal times, which could be managed for a long time, such a structure of the futures market could fail and lead to potential financial disasters similar to the one in 1929.
Risk of Systemic Failure
Many investors consider buying gold as the best defensive investment strategy. They intend to rip large profits from worldwide economic disasters. Many gold investors are wary of financial breakdown due to the global credit base stretched too thin and largely composed of derivatives. Paradoxically, gold futures themselves are derivative instruments, built on about 95 percent of the credit.
Commodities markets attract various speculators who want to profit from rapid price movements. The clearer and the exchange could possibly not receive a critical margin from traders of various commodities. If a large number of traders default on their debts, the clearer and sometimes even the exchange won't be able to cover their losses. In such a situation, a gold investor with significant profits on paper won't get paid at all. As harsh as this situation sounds, this scenario is possible and must be considered.
Not surprisingly the commodity exchange with the most attractive margin terms for brokers will become the most influential and flourishing one. To appeal to investors, brokers must offer generous terms with lucrative multipliers over deposited margins. As a result, the credit limits in a futures market resemble the maximum safe amounts from the previous years. Exchanges following a more conservative strategy usually don't survive and are forced out of the market.
Today's futures exchanges are aggressive risk-takers who practice caution on a rare occasion and operate on the verge of making a reckless decision.
Gold Futures – Summary
For successful gold futures trading, investors must be mentally strong and capable of evaluating a situation objectively. Market professionals are best equipped to work with futures. Also, gold futures are the most profitable in short-term speculations when expected significant changes in prices lower the effects of contango as well as rollover rates. However, it might just be easier to invest with OneGold.
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