A future is simply a deal to trade gold at terms (i.e. amounts and prices) decided now, but with a settlement day in the future. That means you don’t have to pay up just yet (at least not in full) and the seller doesn’t need to deliver you any gold just yet either. It’s as easy as that.
The settlement day is the day when the actual exchange takes place – i.e. when the buyer pays, and the seller delivers the gold. It’s usually up to 3 months ahead.
Most futures traders use the delay to enable them to speculate – both ways. Their intention is to sell anything they have bought, or to buy back anything they have sold, before reaching the settlement day. Then they will only have to settle their gains and losses. In this way they can trade in much larger amounts, and take bigger risks for bigger rewards, than they would be able to if they had to settle their trades as soon as dealt.
Delaying the settlement creates the need for margin, which is one of the most important aspects of buying (or selling) a gold future.
Margin is required because delaying settlement makes the seller nervous that if the gold price falls the buyer will walk away from the deal which has been struck, while at the same time the buyer is nervous that if the gold price rises the seller will similarly walk away.
Margin is the downpayment usually lodged with an independent central clearer which protects the other party from your temptation to walk away. So if you deal gold futures you will be asked to pay margin, and depending on current market conditions it might be anything from 2% to 20% of the total value of what you dealt.
But the same 10% fall will cost you PKR10,000 with futures, which is PKR5,000 more than you invested in the first place. You will probably have been persuaded to deposit the extra PKR5,000 as a margin top-up, and the pain of a PKR10,000 loss will force you to close your position, so your money is lost. If you refused to top-up your margin you will be closed out by your broker, and your original PKR5,000 will be lost on a minor intra-day adjustment – a downwards blip in the long-term upward trend in gold prices.
You can see why futures are dangerous for people who get carried away with their own certainties. The large majority of people who trade futures lose their money. That’s a fact. They lose even when they are right in the medium term, because futures are fatal to your wealth on an unpredicted and temporary price blip.
Big professional traders invent the contractual terms of their futures trading on an ad-hoc basis and trade directly with each other. This is called ‘Over The Counter’ trading (or OTC for short). Fortunately you would be spared the pain (and the mathematics) of detailed negotiations because you will almost certainly trade a standardized futures contract on a financial futures exchange.
In a standardized contract the exchange itself decides the settlement date, the contract amount, the delivery conditions etc. You can make up the size of your overall investment buy buying several of these standard contracts.
Dealing standard contracts on a financial futures exchange will give you two big advantages:-
Note that gold futures are dated instruments which cease trading before their declared settlement date.
At the time trading stops most private traders will have sold their longs or bought back their shorts. There will be a few left who deliberately run the contract to settlement – and actually want to make or take delivery of the whole amount of gold they bought.
On a successful financial futures exchange those running the contract to settlement will be a small minority. The majority will be speculators looking to profit from price moves, without any expectation of getting involved on
HT Commodities Private Limited settlements.
It sometimes appears to unsophisticated investors (and to futures salesmen) that buying gold futures saves you the cost of financing a gold purchase because you only have to fund the margin – not the whole purchase. This is not true. It is vital you understand the mechanics of futures price calculations because if you don’t it will forever be a mystery for you where your money goes.
The spot gold price is the gold price for immediate settlement. It is the reference price for gold all over the world.
A gold futures contract will almost always be priced at a different level to spot gold. The differential closely tracks the cost of financing the equivalent purchase in the spot market.
Because both gold and cash can be lent (and borrowed) the relationship between the futures and the spot price is a simple arithmetical one that 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. Clearly this 0.75% will fall out of the futures price day by day, and this represents the cost of financing the whole purchase, even though I only actually put down the margin.”
You will notice that so long as dollar interest rates are higher than gold lease rates then – because of this arithmetic – the futures price will be above the spot price. There’s a special word for this which is that the futures are in ‘contango’. What it means is that a futures trade is always in a steady uphill struggle to profit. For you to profit the underlying gold commodity must rise at a rate faster than the contango falls to zero – which will be at the expiry of the future.
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 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 force out 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. Without wishing to slur anyone in particular the stop-loss is 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).
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 daily interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63% to the spot price. This is where you pay the financing cost on the whole size of your deal.
Gold is bought as the ultimate defensive investment. Many people buying gold hope to make large profits from a global economic shock which might be 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 about 95% pure 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 else.
Both the clearer and the exchange could theoretically find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous book profits which could not be paid as busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses.
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 which has been safe in the recent past, and any exchange which set itself up more cautiously will have already withered and died.
The futures exchanges we see around us today are those whose appetite for risk has most accurately trodden the fine line between aggressive risk taking and occasional appropriate caution. There is no guarantee that the next management step will not be just a bit too brave.