At FirstGold™, we believe that physical bullion is the best form of saving. While gold futures may seem like you’re investing in a safer future, the reality is that all that glitters is not gold.
Futures were originally developed in order for investors to protect their investments and manage their risks. Hedging prices can change drastically over time and investors are able to use futures and options markets to protect themselves from uncertainty in price movements.
A gold futures contract is essentially an agreement between a buyer and a seller to complete a gold transaction for a fixed price at some specified point in the future. In other words, the buyer and seller agree now upon the price of a certain amount of gold that they must respectively buy and sell on some date in the future, regardless of what the price of gold is on that specific date. The majority of gold futures contracts are for 100-ounces of gold, although there are also some smaller contracts available.
When you buy a gold futures contract, you are essentially promising to buy 100 ounces of gold at the current gold futures price when the agreed-upon expiration date arrives. If you hold the contract until expiration, you are obligated to complete the transaction at that time; however, it is very rare for buyers and sellers of gold futures contracts to make or take delivery of the actual gold. Usually, the gold futures contract is bought back or sold for profit before the expiration date. In fact, most gold futures brokers automatically close the contract trade on your behalf prior to expiration, unless you specifically notify them to the contrary.
Whether you hold a gold futures contract to expiration or trade it beforehand, most gold futures contracts are cash settled – this means that all transactions are on paper, the trading occurs in obligation rather than physical assets. In essence, the buyer or seller of a gold futures contract is speculating on which way the price of gold is going to move. For example, if you are bullish on gold and believe that the price of gold will go up in the contract period, you could be the gold futures buyer and agree to buy gold at the point of contract expiration for the current gold futures price. If your forecast is correct, you will profit because the contract will have become more valuable and you can sell it for a greater price than you bought it for. On the flip side, if you believe the price of gold will go down in the contract period, you could sell a gold futures contract and agree to sell gold at its expiration (note that you do need to actually physically produce the gold in most cases! Settlement is done with the equivalent cash value to the gold you are promising to sell). As the seller, you will profit if gold drops because you could buy the gold back for a cheaper price in the future.
Why trade in speculative gold futures?
The major benefit of gold futures contracts is that they are traded on ‘margin’. This means that only a fraction of the value of the contract has to be paid up front, similar in concept to a security deposit. The margin requirements vary among different asset classes and brokers, but still represent only a fraction of the price of the gold underlying the gold futures contract. Investors are thus able to control a value of gold much greater than the initial cash expenditure required, though brokers will call for additional margin if the price of gold moves significantly in a direction that magnifies potential losses.
While such leverage can be the key to impressive profits, it also increases the danger of equally dramatic losses.
A risky business
Futures are complicated and take considerable effort in learning how to trade them. The short term futures market is very risky, haphazard and irrational. Frequently, the buying and selling activity makes little sense as short-term fluctuations are commonly due to market sentiment, or all the little triggers, hopes, and fears that investors and speculators experience on a day to day basis.
One of the biggest factors in the short-term volatility of the futures market is the very fact that futures contracts are paper assets. Since they are paper-backed by little more than promises, a limitless number can be created out of thin air which causes the market price to swing dramatically. If sentiment among investors is that the gold price will soon increase, a flurry of buying will artificially drive the price up in accordance with expectations; conversely, if too many gold futures contracts are being sold we see the price spiral downwards with no real, rational reason justifying the drop. It’s very possible to lose more than you had planned to in the gold futures market as prices move very quickly; if you over leverage your trades and a big movement in price occurs, you could lose more than you had in your entire margin account, requiring you to make up the negative balance.
Gold futures also exist in a near-perpetual state of ‘contango’, which means that gold futures contracts with an expiration date stretching further into the future cost more than those with a shorter expiration. This means that when you sell one gold futures contract before it expires and buy the next one with a longer expiration, you are locking in a small loss. Long-term investors who don’t anticipate making changes to their portfolios very often will do better by investing in physical gold bullion itself.
To succeed in the futures market is no easy task - you need sound judgement and tough nerves. Futures work best for short-term speculators anticipating large movements in price which reduce the effects of contango and other trading costs involved, and for market professionals seasoned in more frequent trading.