Buying Gold with Gold Futures

What is a gold future? In a futures exchange, a set of terms that defines the date, quality, delivery location and payment method required at settlement is agreed up front by all participants and is defined as a long term standard for a bullion contract. Typically, the standard gold bullion contract is 100 toy ounces. These ‘contracts’ are then issued with dates for settlement which usually fall at the end of each quarter.

Advantages of gold futures:

1. For traders who don’t want custody it eliminates the hassles and costs of Futures exsettlement and storage. This significantly reduces costs.
2. Traders need much less money to participate even in quite large scale. Futures are ‘margined’. In effect you don’t have to pay for what you buy when you buy it, and if you sell reasonably quickly (i.e. usually within a month or two) you will never pay for all the gold you bought. Instead you will pay about 2% of the value up front, and any profit or loss will be adjusted on your down payment and paid back to you net.
3. You can short sell. Provided you buy an equivalent contract back before the contract expires you will have been able to profit from a falling price.
4. The market is deep and liquid.
5. It is quite easy to track the true worth of your futures contract by following the exchange price.

Disadvantages of gold futures:

1. Artificially volatility. Futures have to be closed out periodically, usually every three months, and at these times trading is suspended in the current contract. In the final run up to suspension trading becomes a difficult game of “chicken”, with high volatility, which can be extremely painful for people who do not have the privilege of being on the floor of the exchange.
2. Futures contain a built in price differential which can obscure their true value. When gold is cheaper to borrow than cash the futures price is higher than the spot price. By how much depends on the market’s view of interest rates for cash and gold in the period between buying and suspension. Predicting this is not straightforward. In reality you can usually assume that market arbitrageurs have done the job on their computers and have removed any value differential. What traders need to understand is that if they buy a future at $1.50 above the spot price 30 days ahead of suspension then the value of that future will fall out at about 5 cents a day for the next 30 days.
3. Credit risk. This 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. Almost all futures traders are unconcerned by this risk, but it is material and gold buyers as a breed are aware of it.
4. Automatic instability. With all futures (not just gold) a rapidly falling market will force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price. 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.
5. The stop-loss. The stop-loss sounds like a great idea and is offered and encouraged by many brokers for reasons of safety. But it can work profoundly against the interest of the trader.

Seeing where the costs are in futures trading is not easy to do. A $10,000 margin down payment could probably finance a notional $500,000 gold future purchase, and transaction costs would be very small. But the position would be very thin on margin, and even a touch of weakness in the gold price would see the $10,000 lost.

A more conservative approach would allow some tolerance of a market moving the wrong way. If a $10,000 down payment financed a $100,000 position successfully for a year the costs assimilated over the period would include the commissions (four sales and four purchases) 4 trading spreads on a notional $100,000 position, and the loss of interest on the margin. On the most generous interpretation this will cost about $1,000 – i.e. about 1% of the notional principal but a high 10% of the down payment.

Traders who are prepared to underwrite for a short period the systemic risks of derivatives, gold futures remain a sensible and cost effective way of executing a short-term gold trade.