At FirstGold™, we believe that physical bullion is the best form of saving. While silver futures may seem like you’re investing in a safer future, the reality is that silver futures is just another piece of paper. Is there a silver lining?
A silver futures contract is an agreement between a buyer and a seller to complete a silver transaction for a set price at a specific time in the future. So, in simpler terms, a buyer and a seller negotiate a price for a set amount of silver that they will trade on a prospective ‘due’ date (whether it is months or years ahead) – the market silver price on that due date is irrelevant.
When you enter into a typical silver futures contract, you are committed to purchasing a certain amount of silver at the price you negotiate with your dealer on the due date. However, it is rare for buyers and sellers to actually take delivery of the silver. Most silver futures contracts are bought back or sold for profit before the due date. In the lead up to the date, the majority of futures brokers will actually close the contract trade on your behalf unless instructed otherwise.
Most silver futures contracts are settled in paper money, so trading occurs in contractual obligations rather than solid, physical assets. Profits are made through market predictions. The buyers or sellers must speculate on which direction the price of silver will move in the future. If you correctly predict that silver is increasing in value, you would purchase silver at the current futures price. Your contract will gain value over time because you can sell the silver for a higher price than you bought it for. On the flip side, if you believe the price of silver will go down, then you could sell a silver futures contract and agree to sell silver at its expiration at the higher price of the original futures contract. If you are the seller, you will profit if the silver price does drop as you predicted, because you could buy the silver back for a cheaper price when the expiration date arrives.
Why trade in speculative silver futures?
Silver futures contracts are traded on ‘margin’ – this is their major advantage. Trading on a margin means that only a portion of the value of the contract has to be paid up front. The margin requirements vary from broker to broker and between different asset classes, but still only represent a portion of the price of the silver futures contract. As a result, investors can control a value of silver beyond the initial cash input, though brokers will demand an additional margin if the price of the silver moves significantly in a direction that magnifies potential losses.
This leverage can drive hefty profits, although there is also a risk of equally dramatic losses.
A risky business
As you can see, trading in futures is tricky and requires a great deal of experience and knowledge. The short-term futures market is very haphazard, risky and irrational. Buying and selling activity is nonsensical, because short-term fluctuations are often the result of market sentiment – the hopes, fears and hype that investors and speculators experience each day.
The fact that futures contracts are negotiated through paper money is also a major driving force behind short-term volatility of the futures market. Since futures contracts are backed by little more than promises, a limitless number can be created out of thin air, causing dramatic fluctuations in the market price. If investors believe the price of silver will increase shortly, then the increase in buying created by the sentiment will artificially drive the price up; on the other hand, if too many silver futures contracts are being sold, the price will plummet, with no real, rational reason. The volatility of prices in the silver futures market makes it very easy for investors to lose value. If you over-leverage your trades and a big change in price takes place, you could lose more than you had in your entire margin account, and you will be required to pay for the negative balance out of your own pocket.
Silver futures also exist in a state of ‘cotango’ with no end in sight, so silver futures contracts with long-term due dates cost more than those with short-term due dates. If you sell a silver futures contract before the due date and buy the next one with a longer expiration period in mind, you will make a small loss. Long-term investors who don’t anticipate making many changes to their portfolios are much better suited to investing in physical silver bullion itself.
Succeeding in the futures market takes courage, hard work and a lot of market knowledge. Futures work best for market mavens and short-term speculators anticipating large movements in prices that reduce the effects of cotango and other trading costs. Educate yourself and conduct extensive research before committing yourself to a contract!