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Why is there a thriving gold futures market? Advantages of futures trading Futures risks Futures can be artificially volatile Futures contain a built in price differential The risk of systemic failure Automatic instability The stop loss Rollover psychology COMEX and TOCOM The cost of trading futures
The physical bullion markets repel private bullion investment for reasons of cost, transparency and convenience. Because of this, and the more short term requirements of gold speculators, there is a thriving gold futures market.
Many speculators' requirements can be met by a standardised and transferable quarterly futures contract [footnote - future explained].
The main advantages of this method of trading are
These advantages mean turnover of gold futures contracts currently exceeds actual bullion production by many times. It is not a figure which is easy to estimate, but COMEX turnover on its own exceeds gold production about twenty-fold.
Apart from the obvious risk of prices going the wrong way there is one key risk in futures trading, which is the risk of default during the period from trade to future settlement date - leaving someone entitled to a profit but unable to collect it.
This problem is mitigated by "margin". Margin is money futures investors deposit at the demand of the clearer who seeks to prevent the risk of default from growing too big. It is calculated by comparing the original deal to the current market value of what was traded. The process is called marking-to-market and it results in a margin call to the person who has speculated badly, while a margin surplus grows at the account of the successful trader. The margin is collected and managed by a clearer on behalf of the exchange.
Margin deposited only needs to cover the likely potential loss on the trade which could occur in the time it would take for the clearer to collect more margin. So, for example, on a $400 gold price it might be thought that $20 was the largest likely intra-day move, and that margin could be collected before the next trading day. So to keep off risk the clearer would require the investor to put up margin of 20/400, i.e. about 5% of the contracted deal size.
In practice the margin calculation will vary from exchange to exchange and from clearer to clearer. It is ultimately up to each firm to decide how it implements a margin policy and it's always a compromise between risk and the attractiveness of the product to the client. At any rate, the result is that speculators only have to pay a fraction of the value of the contract’s amount - as a variable down-payment. Provided they close their position before expiry they will never have to put up the rest of the money.
This means that the aggressive speculator can 'gear-up' his position by trading many times more gold than he could ever afford to pay for, and this makes futures very popular with people who have an appetite for bigger risks.
Usually investors only have to deposit about 2% of the full value of gold they want to buy, but their broker will retain the right to close them out without instruction if the market moves viciously against them. Meanwhile on a daily basis investors must quickly top up margin if the market has moved a little against them.
That is the simple basis of futures trading. It is not particularly complicated and need not be risky, but there are some points which deserve special mention.
When a number of big open positions want to close out near to the trading deadline of a quarterly futures contract the prices frequently can start to behave irrationally and with wild gyrations down and up.
This is inevitable where 99 out of every 100 investors want to trade before the end of the day - to close a position which if it is not closed will end up in them having to take delivery of metal and pay 50 times as much as the 2% margin as they have deposited.
The volume is usually so large that the tail of the futures market wags the dog of the spot market, where volumes are much smaller. The market becomes a high stakes game of "chicken" and it is far from unusual to see the price maintained by a big player at a particular rate, only to swerve violently immediately after the contract terms expire. It can make for some frightening action for the uninitiated - and they usually lose out.
It is important to understand the implicit financing cost in a futures price. A dollar denominated gold futures contract will almost always be priced at a different level to spot gold in dollars, but the difference does not represent either a bargain or a rip-off. It actually reflects the different costs of borrowing dollars and gold, from the date of buying to the date of future settlement.
If gold is cheaper to borrow than dollars - which it usually is - then the spot price will be below the future. If gold is more expensive to borrow then gold futures will be at a discount to the spot. The relationship is a simple mathematical 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."
This 0.75% "contango" in the price will reduce day by day as the futures contract approaches its expiry date.
Not often considered is that gold is bought as the ultimate defensive investment. As a gold buyer there should be an intention to make large profits from a global economic shock which is 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 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. Both the clearer and the exchange could find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous paper profits which could not be paid if busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses and themselves went bust.
Imagine successfully buying gold in front of a major financial crisis - and for all the right reasons - only to fail to collect a profit because the settlement system was broke!
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 risk which has been safe in the recent past, and any exchange which sets itself up more cautiously will wither and die.
But in finance the recent past is not always a good guide to the future.
The danger is compounded by the automatic structural instability of futures 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 long periods of time, but it is an inherent danger of the futures set-up.
Indeed the same phenomenon of structural instability 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.
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 it 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 encourage 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).
The structure of the futures market requires that each quarter a contract is closed and the position re-opened again for the next future period. This ‘roll-over’ has a marked psychological effect on inexperienced investors.
Having taken the relatively difficult step of investing some of their savings in gold futures they are required to make repeated decisions to spend money, closing the old contract and re-opening the new just to keep a long gold position open. With futures there is no ‘do nothing’ option, like there is with a bullion investment.
The harsh fact of life is that if investors are right about gold long term and wrong short term many of them who participate via futures will be expelled at rollover date if they have lost money in the previous quarter. It is much harder to pay up and re-invest after a loss than to do nothing, as would be the case with physical bullion securely stored. Investors who fail the psychological test of roll-over will leave their position, rather disappointed not to have made money as quickly as they had hoped, and many will never return to benefit from the long term correctness of their view of gold.
So before deciding if futures are suitable for them investors should seriously consider whether or not they are psychologically equipped to re-buy again and again after disappointment in the previous quarter. Patient but convinced gold bulls who don't like losing money may be better advised to spare themselves this psychological test and buy physical.
The two main world futures exchanges which trade gold are COMEX in New York and TOCOM in Tokyo. These are both general purpose commodities exchanges which trade substantial numbers of futures contracts.
The standard TOCOM gold contract is 1kg and the open investor interest is about 400 tonnes.
The standard COMEX gold contract is 100 troy ounces – about 3.1kg. COMEX open interest data is more difficult to access. An estimate is about 1500 tonnes. COMEX traded volume exceeds 40,000 contracts daily - or 120 tonnes. This is about 17 times as much gold as is produced worldwide on a typical day.
Typical costs for trading gold futures are the bid-offer spread, the commission, and the financing cost of the margin. Note especially that futures trading requires positions to be closed and re-opened regularly – usually quarterly. This rolling-over of a position incurs dealing costs.
The following is an example of the cost of buying a typical 100 oz [approx $40,000] contract, and holding the position open by rolling it 3 times for a 1 year position. The assumptions probably err on the side of understating the costs. Note - especially - that the cost of trading is expressed as a percentage of the underlying principal of $40,000. Were it expressed as a percentage of the margin down-payment it would be considerably higher.
Source of expense Actual expense % Trading spread $400.00-$400.60 per oz $60 0.15% Margin finance $40k * 3% * 5% / 4 $15.00 0.037% Purchase commission $10 0.025% Sale commission $10 0.025% Total per quarter $95 0.237% Total per year $380 0.95%
A note on the financing cost: the avoidance of a financing cost on the consideration of a gold future purchased is sometimes presented to investors as a cost advantage. This is pure financial trickery because the cost of financing the principal of the contract is hidden in the price. Because of this the above table neither adds in the spot-to-future premium of the contango nor the financing cost, and this gives a fairer view of the percentage of capital which is lost to the trading mechanism in futures.
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