Gold futures provide an excellent alternative investment to physical gold and other types of gold investment. For traders or investors who do not want to worry about the storage and security of investing in physical gold, the futures market provides the most direct exposure to gold price movements since the underlying asset is the metal itself. This is in contrast with other types of gold investments such as gold mining stocks and gold mutual funds.
A gold futures contract is a standardised contract between buyer and seller to deliver a standardised quantity of gold at an earlier agreed price for delivery at a specified future date. These contracts are listed and traded on Exchanges; for example COMEX gold futures at the Chicago Mercantile Exchange and TOCOM gold futures at the Tokyo Commodity Exchange.
In this segment, we explore the features and advantages of the exchange traded gold futures contracts.
Margin & Leverage
Margin is the amount of money investors need to deposit and maintain at a certain prescribed level to hold a futures contract. For example, the initial margin for one COMEX gold contract is approximately USD10,000 for 100 troy oz of gold. This enables investors to own a large amount of asset with a smaller amount of capital (margin). For example, if the market price of gold is USD1, 600 per troy ounce, an investor will need to pay USD160,000 in cash to own 100 troy ounces of physical gold. However, by holding one COMEX gold futures contract, investors will only need to pay USD 10,000.
Margin is related to the ability to leverage, which is one of the most distinct advantages in trading futures. Leverage is the most powerful tool available in futures trading as it allows investors to control an asset of greater value compared to their initial investment. Investors are able to efficiently use their capital to boost their returns on their investment. Let us look at an example to illustrate this distinct feature:
If a cash trader buys 100 oz of gold at USD 1,600 per ounce, he would have to pay USD160,000 for the purchase. This is a cash purchase without leverage. If a savvy trader buys one COMEX Gold Futures Contract which is equivalent to 100 oz per contract, he only needs to put up approximately USD10, 000 for the purchase. The COMEX Gold contract has given the savvy trader 16X leverage.
If gold prices were to go up 10%, both the cash and savvy trader would have made USD16,000.
However, the return would have been 160% for the savvy trader whilst the cash trader would only have earned 10%.
Futures trading provide investors with higher appetite for risks an added advantage due to its volatility. Gold prices are highly sensitive to global economic events such as changes in the monetary policy of central banks, financial crisis, wars and other geo-political developments. For example: the recent announcement of the likely tapering of Quantitative Easing by Ben Bernanke in September 2013 has driven gold prices to a three month high. Given the volatility of the underlying market, traders can maximize their profit from the ups and downs of the market with very minimal trading cost.
Ability to short-sell
Futures market has a very defining characteristic which enables investors to short- sell. This means that investors are able to sell the futures contract although the underlying assets are not owned by them. Short- sellers assume that they will be able to buy the futures contract back at a lower price compared to the price as at when the contract was sold. The ability of short-selling enables investors to take advantage of both market trends, even if the market is on a downtrend. This is a clear edge over owning gold mining company stocks or mutual funds as short-selling of stock is prohibited or restricted in many countries. When gold prices are going down and investors perceive that prices are likely to fall even further, they can take a short position in the futures contracts.
The Futures market is considered a shorter term trading form of investment as compared to other investment vehicles. This is where day traders and scalpers come in to profit from this. For example; COMEX gold futures’ minimum price fluctuation is at $0.10 per troy ounce and by buying one COMEX gold futures contract, you are exposed to a profit or loss of USD 10 for every tick movement. COMEX Gold futures typically moves within a range of 200 to 400 ticks a day. Given the volatility of the gold futures market, it is therefore not surprising that investors can make a profit in a very short period of time from the price movements.
Tight Bid/Offer Spread
A key component of trading successfully is to trade in markets with deep liquidity and good volume. This is because with a tighter bid- ask spread (the difference between the buyers price and sellers price), investors are able to enter and exit the market with less slippage and cost. A highly liquid market will always have ample buyers and sellers on both sides of the markets. Hence, investors are able to trade at their desired prices more easily in bigger sizes without sacrificing their profits in terms of bid offer spread cost.
Bursa Malaysia Derivatives (BMD) has launched a Gold Futures Contract. This will give Malaysian investors a great new avenue for investing in gold locally. We will explore the BMD Gold Futures contract in the next segment.