The gold futures market
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
Gold futures trading advantages
- Gold futures trading advantages
- Gold futures trading risks
- Volatility of the gold futures market
- Futures built-in price differential
- The risk of systemic failure
- Automatic instability
- The stop-loss
- The roll-over
- COMEX and TOCOM
- The real costs of trading futures
- Hidden costs at the close or roll-over
- Running through to Settlement
The main advantages of this method of trading are:
- For traders who don't want custody it eliminates the hassles and costs of settlement and storage. This significantly reduces costs.
- Investors need much less money to participate.
- Traders can short sell. Provided they buy an equivalent contract back before the contract expires they will have been able to profit from a falling price. This can only be done on spot markets with great difficulty, because it requires the seller to borrow gold, which is next to impossible for retail investors.
- All participants trade exactly the same notional rights - i.e. those defined on the standard contract, so the market grows deeper and more liquid in the standard futures contract than in spot bullion where different qualities of bullion exist each of which has different prices.
- Greater liquidity provides a reliable real-time price, something which is absolutely not available in the OTC bullion market.
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.
Gold futures trading risks
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.
Volatility of the gold futures market
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.
Futures built-in price differential
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.
This means that when you buy a future you are paying for the cost of financing the entire purchase. In addition, although much less significant, because almost all brokers take the margin you put down into their own account, you are - in effect - paying the financing cost twice on this fraction of the contracted sum.
The risk of systemic failure
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.
The stop-loss can 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. As a futures contract ends an investor who wants to keep the position open must re-contract in the new period by 'rolling-over'. 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.
COMEX and TOCOM
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.
The real costs of trading futures
When a future is traded the broker will frequently compute dealing costs as a percentage of the principal. This is deceptive: The principal has not actually been settled, so the costs of settlement - where most of the real expense lies - have not been borne. The expense in a future is the cost of taking out a notional promise, which one should expect to be pretty low. It is sneaky to quote a percentage on the basis of an irrelevantly large principal when the costs of settling that amount have yet to be added. Were it instead computed as the percentage of the margin - a more relevant figure - futures would look like substantially more expensive instruments to trade.
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%|
|Total per quarter||$95||0.237%|
|Total per year||$380||0.95%|
Hidden costs at the close or rollover
Each quarter a futures investor receives an inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced rate. To those who do not know the short term money rates and the relevant gold lease rates - or how to convert them into the correct differential for the two contracts - the price is fairly arbitrary and not always very competitive.
It can be checked - but only at some effort. Suppose that gold can be borrowed for 0.003% per day (1.095% per annum) and cash for 0.01% per day (3.65% per annum). The fair value for the next quarter's future should be 90 days times the interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63%.
But there are strange extra forces at work. They come from predictable facts about the distribution of gold futures positions:
- The shorts are mostly market professionals. They might well be miners, who traded futures intending to settle, or they might be experienced market operators, but whatever they are they tend to be of substantial size. On the long side the buyers are likely to be smaller scale - maybe jewellers, their suppliers and private speculators (all much more likely as buyers than sellers). So while the gross open interest of longs and shorts is in perfect balance, the average size of position is smaller for the longs and there are correspondingly more of them.
- The longs, being smaller, have a predictably larger cost of borrowing to finance settlement.
Suppose the old future is fairly priced at 100. The normal spread is - we'll say - 0.20%. So a typical roll-over - selling the old and buying the new - would trade from 99.9 (selling the old future at 100 less half the spread) to 100.73 (buying the new future with the 0.63% of financing cost + half the spread). There would also be commission on top, but that is not hidden. That 0.63 of the differential represents the financing cost of the entire principal for the new period (described above).
In addition the trader can improve his profitability, because of the different profiles of longs and shorts. What he does is anticipate the likely direction of a random customer who contacts him, and the nearer the end of the period the more the odds are stacked that whoever is on the phone will be selling a small quantity to close the old future. Of course these should be balanced by the occasional large purchase, but as we will see that can be got round.
The trader artificially lowers both his trading price, and his liquidity. The quote becomes 99.825 - 100.655 (remember the 0.63 of finance cost) sized in one lot, not ten.
It seems to the casual eye that there is still a 0.2% spread, but is there? Look at the following table - constructed on the basis that there are ten small sellers and one large buyer. Because the trader has reduced his liquidity the big buyer has to execute three trades (at different prices) to buy what he wants to close.
|-1 old (bigger customer wants to do 10)||+100.655|
|-4 old (adjusted price on larger purchase order)||+100.73|
|-5 old (adjusted price again to complete larger purchase order)||+100.755|
Do the arithmetic and you'll see the trader has engineered to buy from sellers 10 lots at an average price of 99.825 and to sell to buyers 10 lots at an average price of 100.735. It might look like a trading spread of 0.2% when it's quoted (without the financing cost) but it's actually 0.38%. The trader's profit has increased by 90% because of his successful anticipation of the distribution of orders, and 10 private investors' profit has diminished by 0.075%. Exactly the same thing happens on the purchase side in the new futures period.
So in effect, on a trade which is commissioned at only $10 for the pair the actual cost hidden in rollover spreads is $40,000 * 0.0038 - or $152 on each leg.
Please note - these figures are an illustration. It is very hard to compute the reality, because private investors do not usually know the traders' end of the equation or the implied financing cost. Nevertheless the object of the example is to show a potentially substantial and opaque cost which dwarfs the 'low' commission. Both accrue to the trader. Private futures speculators have felt the result when they notice that while the spot price doesn't seem to have moved much, for some reason the futures position is costing money to keep open.
Perhaps you could rollover early to avoid the problem. If you try you'll find plenty of liquidity in the old future but hardly any in the new one. You'll fall victim to much the sort of same mechanism on the other side.
Running through to Settlement
Meanwhile the professionals are busy fixing to finance settlement - a luxury not usually available to the private investor. A big futures player can probably arrange a short term borrowing facility for 3% and borrow gold for 1%, whereas a private investor cannot borrow gold and might pay 12%-15% for money which prices settlement out of his reach, even if he had the storage facility and other infrastructure in place to take delivery. The known imbalance allows a few large shorts to elect for settlement (i.e. not buying back the future to close) and this cannot easily be duplicated by the longs. A shortage of buyers in the old futures contract develops at the death and it depresses the price for small bulls trying to sell and buy back in the new period.
How low? Clearly there is a floor - because bigger participants will come in to snap up cheap futures selling bullion on the spot market financed by a gold loan (which keeps their book balanced overall). But the futures price must fall low enough to enable them to profit from the arbitrage. It turns out the lowness of the price relates to the hassle cost of small deals and physical delivery. Trades have to be executed, matched, margined, reconciled, delivered, weighed etc, and all of this takes people, systems, time and money. Moreover because the professionals all have electronic processing facilities connected to each other the error rates on small private investor trades are the largest and many even require customer side paper as well as salesman time on the telephone, to say nothing of a raft of regulatory obligations which don't exist for trades between market professionals.
As a result the trade processing costs of small trades are actually bigger than professional trades of many times their value, and the profitability on transacting them is reduced. So arbitrage buying support doesn't appear until there is enough margin in the arbitrage to pay for the costs of many small and expensive-to-process trades and the hassle of physical delivery.
All this is predictable by professionals - and it is self-justifying because it encourages more professionals, and anyone who can borrow gold cheaply (a privilege only available to big corporates) to be short at the death even if they have no specific gold view. Private investors usually lose out.