The Ins and Outs of Investing in Gold Futures
Futures are complex financial instruments that can be used for speculation or hedging purposes. They give the investor much more bang for his buck because of the way in which they are financed. But this also means there is a far greater risk attached, particularly for the inexperienced investor.
What is a Gold future?
A gold future is the obligation to buy a certain amount of gold at a certain price, decided at the time the future is bought, on a certain date in the future. The buyer doesn’t have to pay the cash now, because the seller hasn’t delivered the gold yet. Usually futures are not actually settled. The buyer and the seller are not trading to accept delivery of gold or payment of the cash for the gold, but as a way to speculate on the price of gold. So futures are most commonly closed out before settlement day, or rolled over to the next settlement cycle.
So if you don’t pay for the gold, it’s a free bet, right?
There’s no such thing as a free lunch, and certainly no such thing as a free bet! When you trade futures, the market recognises that losses can mount up very quickly. Part of the reason for this is that a single futures contract is based on 100 troy ounces of gold (at a gold price of $1600, that’s $160,000). A 2% movement against you will cost 2% of the value of the futures you have bought, or sold.
In order to ensure you have the necessary fund to suffer any losses, the market charges you a margin. The amount of this margin depends upon current market conditions, and can range from around 2% of the value of your position to 15% or even 20%. This margin is calculated daily, so through the period that you are holding the future further margin may need to be posted if the gold price continues to move against you.
Ok, so not a free bet, but a cheap one?
Well, effectively, yes. Because you are only paying the margin required, you are able to take a much larger position than if you had, for example, bought gold bullion. If the margin requirement is, say 2% and the price of gold is $1600, you could have exposure to $160,000 worth of gold by buying the future for a down payment of $3,200.
If gold moves up by 5%, you would make a notional $8,000, but had you invested your $3,200 in gold bullion your profit would be only $160. Effectively you are borrowing money to invest. It is this leveraging that gives your position such great gearing.
What investors tend to forget when they start trading futures is that while the upside is geared, so too is the downside. The risk of sustaining huge losses is just as great as the potential for massive profits.
There is also a hidden cost when trading futures. The settlement of a future takes place sometime in the future, and so there is a greater possibility of your trade turning into profit, because of the time you have for it to do so. The futures market realises this and prices the future accordingly. As the future moves toward expiry date, this premium erodes, until it eventually hits zero. Had you bought the physical gold, you would not have paid this time premium.
What if I want to remain exposed to gold through futures?
Ok, so you bought a future and you’re in profit. But settlement is approaching and you don’t have the funds to buy the physical gold, and you certainly don’t have anywhere to store it. If you want to remain exposed to the gold price, you can transact a ‘rollover’. But this does not come without a cost. When making a rollover, the difference between the fair value of the new contract and the fair value of the old contract, plus any difference in strike price (if any).
Are there any other risks I should be aware of?
Because the margin requirements are so small, in a rapidly falling market a future exchange’s members will reserve the right to automatically close out losing positions. They have to do this to protect themselves from margin requirements that their clients cannot satisfy.
What this means is that as the market falls, further selling could be forced, causing the price to fall further and faster than in a traditional market place.
The gold futures market trades with high liquidity and offers investors a leveraged platform to speculate on the gold price. However, this gearing also increases risk, and there are hidden costs that can be difficult to calculate. The market is dominated by large institutional investors and metals companies, and so the small investor is often side lined.
For all these reasons, whilst the potential profitability achievable by dealing in futures is tempting to many, it is a market that is taken best advantage of by experienced investors.