A Guide to Trading Gold and Silver Futures Contracts

The GoldSilver Team 

There are two primary ways to invest in precious metals: buying physical metals and via futures contracts.

Futures markets are electronic trading markets where buyers and sellers trade contracts based on the ability to take delivery of a certain amount of gold at a certain price on a certain future date

Though they technically involve the eventual delivery of large amounts of physical gold, the vast majority of trading in futures markets is done as short-term speculation and very few traders ever receive (or want to receive) physical gold, as they’re bought and sold well ahead of the dates such delivery is due

The futures markets are complicated, expensive, risky, and full of extremely experienced professional traders. We do not recommend participating in them, especially as a novice investor (or any investor who seeks, first and foremost, to protect their wealth)

Owning Physical Metal vs. Trading in the Futures Market

Physical metals are fundamentally simple. You own metals. When prices of stocks or local currencies fall, metals prices usually rise, and vice versa. You aim to buy when metals are cheap (usually when everything else feels too expensive), and you sell when they rise to maintain your overall portfolio value and purchasing power.

Precious metals futures, on the other hand, are rather complicated, very expensive, and particularly risky. For the average retail investor, this market is probably not a good fit. Thus, as a company, futures trading is not a service that we offer. We deal in physical gold and silver only, the volatility of which are not nearly as extreme as the chaotic action of the futures prices. Physical metal is always going to be a store of value, whereas a single wrong-way bet on a futures contract can bankrupt you.

But for those who are interested in the added leverage that futures speculation can provide (and can handle the rollercoaster volatility), what follows is a primer on how this interesting but daunting market actually works...and how it affects the price you pay for a 1 oz Gold Eagle.

What Is a Futures Contract?

A futures contract is a legally binding agreement to buy or sell a commodity that is made between two parties (there are futures contracts for other financial instruments, as well, but we’re not concerned with them here). The contract specifies the quantity of the commodity, along with the location, date, and time where payment and delivery will be settled.

For simplicity, we’ll stick to gold futures because gold is the most commonly traded precious metal and the others, like silver, work effectively the same.

All futures trading is based upon the spot price of gold at the delivery date of the contract. The buyer agrees to buy a specific amount of gold at a fixed price on a specific settlement date, which is generally the last day of the contract month three months out (though contracts can sometimes be rolled over), and is legally entitled to take delivery of the metal if the contract is exercised. The seller agrees to furnish physical gold in that quantity, at that price and on that date, if it is demanded. Buying is called going long, and selling is called selling short.

For each transaction, someone must go long and someone must sell short.

Note: You’ll sometimes hear “short sellers” referenced in the media, quite often negatively. This shorthand really refers to those people who borrow commodities (or stocks, bonds, or other trading vehicles) they don’t own in order to sell them as a pure speculation, versus those who sell positions they actually own or, with commodities, expect to mine/harvest by delivery date. The former is a “naked” short seller, and the latter is a covered one. At times, naked short sellers get a bad rap in the media as causing excess market volatility.

We’ll leave that debate to others, but it’s worth understanding being a short seller is not inherently “bad” in this context.

The majority of these positions are initiated by companies who mine gold, setting up their buyers before the commodity comes out of the ground, which is good business practice to ensure the price will cover the costs they expect to incur. They are “short” not in the sense of a stock market investor who borrowed shares to speculate prices would fall, but in the sense that a broken down excavator could leave them short on gold by delivery time and they’ll have to use their cash — which is guaranteed in a process called margin outlined below — to buy back that promise or buy other gold to fulfill it.

That process of sellers ensuring prices before incurring costs, and the inverse of buyers locking in their supply prices and amounts with some predictability ahead of time, was the entire original point of futures markets for gold, oil, and other commodities before pure speculation for shorter-term profit got mixed in.

Price Discovery

Every day, the gold price fluctuates according to the market of those buyers and sellers, but there has to be a starting point. This happens with the establishment of the London Bullion Market Association (LBMA) Gold Price (usually referred to as the London Fix) at 10:30 a.m. London time each business day. The price is set by a consortium of large banks that deal in major bullion purchases and sales. Though specifically meant for settling contracts between members of the London bullion market, the London Fix is used as a benchmark for initial pricing of the majority of gold products and derivatives throughout the world's markets. There is also an “evening fix” at 3:00 p.m. London time that sets the overnight price.

The London Fix, though tailored to the futures market, also sets the initial daily “spot price” of an ounce of physical gold, for measuring those widely reported daily gains or losses from an agreed upon starting point (an important feature in a world of virtually 24/7 markets).

After that, gold’s price fluctuates throughout the day, depending upon action in the futures market. Just as with a stock exchange, the constant shifting of investor sentiment creates a continual process of price discovery. The difference being, as noted, that futures trading happens through standardized contracts rather than with shares. And the end result is that the changing futures price trickles down to the retail level, where it becomes the spot price for an ounce of gold, i.e. the base price you pay for that coin.

The futures exchange where such contracts are traded is called the COMEX (now part of CME Group). This exchange floor enables price discovery through an auction-like process. There are always bid prices from buyers and ask prices from sellers, and contracts are forged when the two come to agreement. The exchange behaves as a mediator and facilitator by standardizing the quality, quantity, delivery time and place for settlement of a contract.

Paper Gold

The value of these contracts fluctuates according to the prices of gold and silver, with the quantity always the same. One gold futures contract is for the purchase or sale of 100 troy ounces of 99.5% minimum fine gold. (A silver futures contract is for the purchase or sale of 5,000 troy ounces of 99.9% minimum fine silver.) If gold is trading at, say, $1,350 per ounce, then a buyer would have to agree to a futures contract valued at $135,000.

Of course, you can’t just walk into the COMEX, plunk down your 135 grand and walk away with a contract. Contracts must be negotiated through certified, independent clearing houses that act as brokers. If you want to play the game, you must first open an account with one of them.

It’s important to remember that, despite the effect the futures market has on the spot price of gold at the retail level, this is all paper gold. The COMEX states that it trades contracts, on a daily basis, equivalent to 27 million ounces of gold. Now, no one is buying or selling anything remotely close to that amount of physical metal.

Sure, it does occasionally happen that someone needs to buy or sell real gold in 100-oz. lots. But the vast majority of contracts written are never exercised. They are simply closed out before the settlement date.

Who, then, trades in futures?

The traders in this market are usually either hedgers or speculators.

Hedgers buy or sell in the futures market to manage price risk. This means that they protect themselves against price fluctuations by securing a future price for a commodity. An example of a small-scale hedger would be a jeweler who has to deliver a set number of gold pieces at a given future point. He has already told the customer the retail price. If the price of gold increases in the interim, he will have to bear the brunt of this discrepancy. Therefore, his price margin between raw materials cost and retail price would suffer. Instead, he can buy a gold futures contract to hedge the potential risk. He takes delivery of the gold when he needs it, at a price that locks in his profit.

Much more commonly, though, hedges are taken by the big bullion banks that trade gold in quantities greater than 100 ounces. When they face moving a large amount of gold in or out of their vaults, they can’t afford to be blindsided by a sudden price movement. So they hedge.

Speculators, on the other hand, do not aim to minimize risk. In fact, they embrace risk and try to profit from anticipated movements in price. For example, an investor who thinks gold prices are bound to rise will go long gold futures; one who foresees a price drop will sell short. This is where the big money is made and lost, but it’s an extremely risky game to play. The solitary speculator is usually going up against hedges put on by huge financial institutions with the resources to better understand the markets and even to turn many transactions in their favor. In addition, the big banks themselves may also be speculators.

Occasionally, however, a major speculator may take delivery of physical metal.  This is what Warren Buffett famously did in 1998, when he bought 130 million ounces of silver. Many saw this as a blatant attempt to manipulate the market, although the Wizard of Omaha claimed he was merely making what he saw as a good long-term investment.

What is Margin?

Margin debt plays an important role in futures exchanges.

A margin loan has two components: the amount a borrower has as collateral, i.e. the reserve, and the ratio he can borrow to that underlying collateral. The reserve is the amount of cash or other acceptable collateral that an investor must put up to secure his loan. It can range from 5 to 20% of the contract value, and is deposited with his broker.

The margin reserve serves two purposes: first to ensure a market participant--buyer or seller--will honor their contracts when they mature; and second, to cover the potential loss if the market goes against the trader. For example, a trader borrows money to go “long” gold futures, and the price drops instead, thus the borrower owes more than his holdings are now worth and is at risk of defaulting on his loan. The margin reserve will be more than that loss, typically.

What happens if the market goes so far against the trader that the deposit is no longer enough to cover the loss? The broker then issues a margin call. This means that the trader must either immediately settle the contract and take the hit, or deposit additional money to the account in the hope that things will turn around before the final settlement date. In other words, traders should almost never find themselves underwater in normal markets by more than their reserve can cover. If they get close, they’ll be forced to put up more reserve or close the positions and settle up.

This margin debt means that both gains and losses can be amplified significantly. For example, if a borrower takes full advantage of a 5% margin reserve requirement, buying 20x the futures that his cash would allow, then for every 1% increase (or decrease, if they are “short” the market) in the price of gold, the investor would make 20x that in profits on their original cash. On the other hand, they stand to lose 20x if it goes in the opposite direction of their bet.

There is nothing that says you must use margin to invest in futures, but the majority of participants choose to.

Advantages and Risks of Gold and Silver Futures

The advantages of a futures contract include flexibility and financial leverage.

As you only have to put up a small amount as margin to trade in futures, you have financial leverage; initially, you spend only a fraction of the actual contract value. And since many sellers and buyers have no intention of holding their contracts until the settlement day, you have ample time to cash in your gains or cut your losses.

Trading in futures also offers flexibility as you can easily assume both long -- i.e. you profit when metals prices rise, similar to holding physical metals -- and short positions -- where you make money when prices fall, which is much easier with these paper contracts than using actual physical metals. Because of the sheer number of trades happening, what the market calls “liquidity”, you can quickly terminate either a good or a bad speculation, by buying or selling an equivalent contract on the other side from your initial investment.

However, as we keep stressing, there is always great risk involved with futures. By the very nature of leverage, an investor who can make great profits can suffer equally great losses in times of severe volatility.

Hidden Costs

The financial leverage of a futures contract may make you think that you are saving money on the actual price of a purchase. However, it is much more complicated than that.

The difference between the “spot” gold price – i.e. the price of immediate settlement, on the spot – and a gold futures contract accounts for financing the equivalent purchases to happen later. Otherwise, the seller would just sell their gold for dollars in the market.

This can be a little complex to understand at first. But the basic concept is this: If gold is cheaper to borrow than dollars - which it usually is - then the spot price will almost always be below the future price. If gold is more expensive to borrow, then gold futures should be at a discount to the spot. In other words:

"My future purchase of gold for dollars (i.e. my long position in a gold futures contract, which is an agreement to do just that, buy gold with dollars in the future) 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. 

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% (usually earned by lending it out to short sellers), I should expect to pay over the spot price by that difference of 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."

The 0.75% is known as contango, which decreases in absolute value nearing the date of settlement on a contract.

Managing Volatility

When dealing with an inherently volatile asset, traded on leverage, it is important to control your risks carefully. For that reason, investors employ lots of automated controls on their positions to limit risk and try to increase their overall profits. These range from order types like ‘limit,’ which specifies the highest price you’ll pay to get into the market; and ‘stop-loss,’ which triggers an automatic sale when things go poorly.

Those stop-loss types, for example, are standing orders a trader gives to his broker, mandating that his contracts be automatically terminated should the price move against him to reach a predetermined level. It is a move the trader primarily makes in order to prevent a bad speculation from bankrupting him if the market moves faster than he as a human with other things to do can react to it.

Sounds like a great strategy, right? But stop-losses can also be manipulated against you to generate profits by professional traders.

Let’s say it’s a slow day on the exchange and a professional trader puts out a large request to sell at an especially low price. With enough volume, that price alone can push down the market’s price temporarily. As the market price falls, this could trigger a stop-loss put on your shares to be triggered, forcing the broker to sell your position. That professional trader then scoops up your contracts at an artificially-suppressed price, then waits for the market to recover -- all in a matter of a few seconds or minutes, mind you -- then sells your contracts for a quick profit. The pro can do this the other way too, pushing short positions out of their stop-losses when the price rises from an artificially high bid, cleaning up thanks to his moment-to-moment knowledge of the prices at which everyone is willing to sell and his ability to move the market by a few pennies here or there.

This tactic, known as ‘quote stuffing’, only works if you can place orders that are large enough to effectively force prices up or down. Thus, it’s most often employed by huge professional trading firms, which have sufficient resources to run it. 

This is just one simple example of how the leverage and complexity of futures markets can be difficult for individual investors to navigate.  If you are planning to invest in futures on top of physical metals, be sure to work with a broker with a sophisticated trading setup who can help you navigate the markets and/or really educate yourself.

Futures Rollover Psychology

One more important aspect to keep in mind is that, unlike a bullion investment where you can just buy and hold indefinitely and wait out the market’s fickleness, one cannot sit idle with a gold futures contract. Every quarter, the market requires you to close a contract and re-open the position again. This process can put some psychological pressure on investors because without being able to see the fruits of their long term labor, they may only see short term losses. This is because a loss in the previous quarter means you are expelled at the rollover date, which means you have to consciously re-invest and retain confidence in your decision.

Summary

This article is intended to be an informational guide to the precious metals futures markets. It’s by no means comprehensive. And, it should not be taken as encouragement to get involved in futures trading. We believe that’s best left to the deep-pocketed, sophisticated and risk-tolerant speculator. In other words, proceed with extreme caution.

Most investors are better served by treating physical gold and silver as core elements in a portfolio, buying and holding them for the long term role they play in mitigating volatility, not adding to it.




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