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May 14 2011| Filed Under Derivatives, Futures, Gold, Hedge Funds, Options
If you are looking for a hedge against inflation, a speculative play, an
alternative investment class or a commercial hedge, gold and silver futures
contracts can be a viable way to meet your needs. In this article, we'll cover
the basics of gold and silver futures contracts and how they are traded. But be
forewarned: Trading in this market involves substantial risks, and investors
could lose more than they originally invested.
Tutorial: Futures Fundamentals
What Are Precious Metals Futures Contracts?
A precious metals futures contract is a legally binding agreement for delivery
of gold or silver in the future at an agreed-upon price. The contracts are
standardized by a futures exchange as to quantity, quality, time and place of
delivery. Only the price is variable. (For more insight, see the Futures
Fundamentals tutorial.)
Hedgers use these contracts as a way to manage their price risk on an expected
purchase or sale of the physical metal. They also provide speculators with an
opportunity to participate in the markets without any physical backing.
There are two different positions that can be taken: A long (buy) position is
an obligation to accept delivery of the physical metal, while a short (sell)
position is the obligation to make delivery. The great majority of futures
contracts are offset prior to the delivery date. For example, this occurs when
an investor with a long position initiates a short position in the same
contract, effectively eliminating the original long position.
Advantages of Futures Contracts
Because they trade at centralized exchanges, trading futures contracts offers
more financial leverage, flexibility and financial integrity than trading the
commodities themselves. (For related reading, check out Commodities: The
Portfolio Hedge.)
Financial leverage is the ability to trade and manage a high market value
product with a fraction of the total value. Trading futures contracts is done
with performance margin. It requires considerably less capital than the
physical market. The leverage provides speculators a higher risk/higher return
investment. (For related reading, see The Leverage Cliff: Watch Your Step.)
For example, one futures contract for gold controls 100 troy ounces, or one
brick of gold. The dollar value of this contract is 100 times the market price
for one ounce of gold. If the market is trading at $600 per ounce, the value of
the contract is $60,000 ($600 x 100 ounces). Based on exchange margin rules,
the margin required to control one contract is only $4,050. So for $4,050, one
can control $60,000 worth of gold. As an investor, this gives you the ability
to leverage $1 to control roughly $15.
In the futures markets, it is just as easy to initiate a short position as a
long position, giving participants a great amount of flexibility. This
flexibility provides hedgers with an ability to protect their physical
positions and for speculators to take positions based on market expectations.
(For related reading, see What is the difference between a hedger and a
speculator?)
The exchanges in which gold/silver futures are traded offer participants no
counterparty risks; this is ensured by the exchanges' clearing services. The
exchange acts as a buyer to every seller and vice versa, decreasing the risk
should either party default on its responsibilities.
Futures Contract Specifications
There are a few different gold contracts traded on U.S. exchanges: One at COMEX
and two on eCBOT. There is a 100-troy-ounce contract that is traded at both
exchanges and a mini contract (33.2 troy ounces) traded only at the eCBOT.
Silver also has two contracts trading at the eCBOT and one at the COMEX. The
"big" contract is for 5,000 ounces, which is traded at both exchanges, while
the eCBOT has a mini for 1,000 ounces.
Gold Futures
Gold is traded in dollars and cents per ounce. For example, when gold is
trading at $600 per ounce, the contract has a value of $60,000 (600 x 100
ounces). A trader that is long at 600 and sells at 610 will make $1,000 (610
600 = $10 profit, 10 x 100 ounces = $1,000). Conversely, a trader who is long
at 600 and sells at 590 will lose $1,000.
The minimum price movement or tick size is 10 cents. The market may have a wide
range, but it must move in increments of at least 10 cents.
Both the eCBOT and COMEX specify delivery to New York area vaults. These vaults
are subject to change by the exchange.
The most active months traded (according to volume and open interest) are
February, April, June, August, October and December.
To maintain an orderly market, the exchanges will set position limits. A
position limit is the maximum number of contracts a single participant can
hold. There are different position limits for hedgers and speculators.
Silver Futures
Silver is traded in dollars and cents per ounce like gold. For example, if
silver is trading at $10 per ounce, the "big" contract has a value of $50,000
(5,000 ounces x $10 per ounce), while the mini would be $10,000 (1,000 ounces x
$10 per ounce).
The tick size is $0.001 per ounce, which equates to $5 per big contract and $1
for the mini contract. The market may not trade in a smaller increment, but it
can trade larger multiples, like pennies.
Like gold, the delivery requirements for both exchanges specify vaults in the
New York area.
The most active months for delivery (according to volume and open interests)
are March, May, July, September and December.
Silver, like gold, also has position limits set by the exchanges.
Hedgers and Speculators in the Futures Market
The primary function of any futures market is to provide a centralized
marketplace for those who have an interest in buying or selling physical
commodities at some time in the future. The metal futures market helps hedgers
reduce the risk associated with adverse price movements in the cash market.
Examples of hedgers include bank vaults, mines, manufacturers and jewelers.
(For more insight, see A Beginner's Guide To Hedging.)
Hedgers take a position in the market that is the opposite of their physical
position. Due to the price correlation between futures and the spot market, a
gain in one market can offset the losses in the other. For example, a jeweler
who is fearful that she will pay higher prices for gold or silver would then
buy a contract to lock in a guaranteed price. If the market price for gold/
silver goes up, she will have to pay higher prices for gold/silver. However,
because the jeweler took a long position in the futures markets, she could have
made money on the futures contract, which would offset the increase in the cost
of purchasing the gold/silver. If the cash price for gold/silver and the
futures prices both went down, the hedger would lose on her futures positions,
but pay less when buying her gold/silver in the cash market.
Unlike hedgers, speculators have no interest in taking delivery, but instead
try to profit by assuming market risk. Speculators include individual
investors, hedge funds or commodity trading advisors.
Speculators come in all shapes and sizes and can be in the market for different
periods of time. Those who are in and out of the market frequently in a session
are called scalpers. A day trader holds a position for longer than a scalper
does, but usually not overnight. A position trader holds for multiple sessions.
All speculators need to be aware that if a market moves in the opposite
direction, the position can result in losses. (For more insight, see
Introduction To Types Of Trading: Scalpers, How To Scalp Fundamentally and
Scalping: Small Quick Profits Can Add Up.)
The Bottom Line
Whether you are a hedger or a speculator, remember that trading involves
substantial risk and is not suitable for everyone. Although there can be
significant profits for those who get involved in trading futures on gold and
silver, remember that futures trading is best left to traders who have the
expertise needed to succeed in these markets.
by Hank King
Hank King currently works at Trendphonics at the Chicago Board of Trade as a
senior broker. He has been in the business since 2000 and has worked as a
Nasdaq trader for Great Point Capital, a clerk on the floor of the CBOT with
Fimat and as an account executive with Morgan Stanley and Lind Waldock. King
has his Series 3 license and graduated from the University of Arizona with a
major in art history.