What are Gold Futures?

October 31, 2018

Image of what are gold futures on the stock exchange

What are Gold Futures and why do they matter to the average investor?

The investment arena is pretty crowded. But it has nothing on the options and futures markets. Envision these financial markets as a giant nexus of transactions. In this nexus, each payment connects to the next in a massive web of buying and selling. On a macro- level that's very much what it's like. Like most speculative endeavours, understanding what are gold futures is an exercise in abstraction.

While you will not have grasped the full complexity of these investments until you know the rules and regulations involved, we can give you the fundamentals. Be warned, as Lucinda Shen reports, Warren Buffett has repeatedly called derivatives "financial weapons of mass destruction".

Understanding derivatives helps answer what are gold futures.

For those of us unfamiliar with derivatives, we are going to start with a few lines explaining something more basic: hedging. You are probably familiar with the basics of insurance. Simply put, you pay an amount on a regular basis and when s*** hits the fan, you get to collect and cover your losses.

The insurance company acts like a giant bank account. You pool money and when things go wrong, you have savings.But what if things go wrong before you have enough back-up? Well, the insurance company balances that risk across many policyholders.

In doing so, it reduces risk of unexpected events occurring and can rely on statistical baseline risk. It makes money by charging you a premium above this risk, and also from investing your payments.

But that is not the only kind of insurance. Let's say you are a farmer and are afraid wheat prices will fall this year. You can also insure your farm by contracting with a buyer that you will sell at $4.50 per bushel for 2019. Or let's say you are a small gold mine. You can contract with a refinery that you will sell 1000 kg of gold (the amount you expect to find in the ground) at USD $1,250 minus fees. Now you can go ahead with the project and not worry about the price going down.

The cost? Well, you lose out on any upside, and you might have to pay a premium to cover the risk. Normally, you would not have to because the refinery can then what are gold futures (promises) to be delivered at $1,250 into the market. The buyer here is someone who is betting against the price of gold going up.

Investing in Gold is conceptually straight forward.

So what are Gold Futures and how do people invest in them? Let's start with the basics of investing in Gold. For the most part, investing in gold bullion has little to do with the stock market. There are forces of supply and demand that impact the "spot" price per 1 ounce of gold. You then pay a premium to get that material in physical form packaged and delivered. That’s not very abstract or complicated.

There are, however, some fancy stock market trends that have become popular over the past few years. These are opportunities for the avid gold investor to consider, although oftentimes they tempt you with highly speculative fortunes.

One such trend is the trend towards derivatives, i.e. investment contracts that derive their value from other investments. So naturally, trading fixed contracts based in the price of gold is a way of trading derivatives.

Investing in Gold Futures is much more complex. But what are Gold Futures?

To answer what are gold futures, let's make the analogy of trading as betting on the price of gold in the near future. In fact, this is very much what is going on. It is also why gold futures can be very useful for industries that need protection against uncertain future prices. So what forms can this bet take? It can either be a short (you bet it will go down) or a long (you assume it will go up). The logic of futures is that you stand to make money by predicting the movements of the gold market.

Anyone can technically make a contract for the future sale or purchase of a certain amount of gold. To get into trading what are gold futures in the marketplace, however, you have to sign a contract. The contract stipulates how much gold you control, the time at which you promise to buy or sell the said amount of gold, and the location from which you are based. When trading on COMEX, all transactions are monitored by the Chicago Mercantile Exchange (CME). This keeps tabs on how much the market is fluctuating.

What are Gold Futures doing that makes them popular with speculator?

Two key points answer what about Gold Futures makes them so popular.

First, allow speculators to control more gold than they could own. Hank King explains how one futures contract controls 100 troy ounces of gold. So someone who would rather not buy gold bullion can buy gold futures and get directly involved in the weekly price of gold. It’s basically a way to limit price risk.

Second - at least when trading on the COMEX - the exchange commission backs every contract. That means if one party has to default, the other party will have it paid to them by the CME. The challenge is what would happen if a general panic took over? Could the commission really pay out all of its contracts that quickly?

What are Gold Futures' downsides?

Enticing as they might look, Gold Futures are far from all rosy. Here are a few reasons they might not be the most effective investment vehicle.

Exposure to Increased Volatile.

A random drop in gold prices could easily happen during the week in which you are obligated to sell.

You're locked in good or bad.

What are Gold Futures if not signed promises? Unfortunately, you have little flexibility when it comes to getting out. If your contract is to buy at over the current spot price, it could be worthless. You are making bold assumptions and lose the collateral value of the physical metal.

The Price is too High.

The structure of gold futures makes them ideal for rich investors or hedge funds to engage with. Unfortunately, the average single investor with a few hundred or thousand dollars is going to have a harder time investing in gold futures.

Gold Mining is Strong.

Approximately 3,100 metric tonnes of gold were mined in 2016, and it’s expected the same amount – or more - will be reported in 2017. If it turns out higher, the price of gold may drop slightly. Thus, you may bet against gold.

Gold Futures vs Physical Gold is a question of stability.

If you are not trading in the tends of thousands of dollars - at least - then gold bullion may be a much cheaper option. That's because of the transactional costs of maintaining and trading in a futures account. If you really want to go short (invest against gold) you should look instead to Electronically Traded Funds (ETFs). In this case, look for ETFs that are betting against gold (or another precious metal).

With that in mind, when you are going long gold, it makes little sense to own paper gold especially if you are not intent on actively trading it. We are not and do not hold ourselves out to be investment advisors. In our experience, trading short can be extremely dangerous (as is any speculation) and with futures contracts, you are betting on the future.

We are not confident in our abilities to predict price changes, especially in the very short term. And that's exactly what you are doing with short-selling... Moreover, if you are wrong going short, you could be liable for theoretically unlimited losses as the price goes up.



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