Gold and silver futures are traded on several exchanges across the globe. These instruments can give investors exposure to gold and silver while only putting up a fraction of the total cost of the contract. Because of this leverage, gold and silver futures are not to be taken lightly and are certainly not appropriate for all investors.
Futures contracts were first traded in the mid-19th century with the establishment of a central grain market. This central grain market gave farmers the ability to sell their grain for immediate delivery in what is known as the spot market, or they had the option to sell their grain for a certain price for a future delivery date. A futures contract is a legal agreement between the buyer and the seller for the purchase or sale of an asset on a specific date during a specific month.
The purchase and sale of futures contracts is facilitated through a futures exchange and is standardized in terms of quality, quantity, and delivery time, as well as delivery location. The price of a futures contract is not fixed, however, and is constantly in a state of discovery through an auction-like process on exchange trading floors and/or electronic trading platforms. In the case of gold or silver, a futures contract outlines a specific delivery time and place for “good delivery” gold or silver bullion.
The use of futures contracts generally falls into two broad categories: hedging and speculative purposes. A hedger uses futures contracts to try and mitigate their price risk in an asset, while a speculator accepts this price risk in order to try and profit from favorable movement in prices. The market needs participation from both hedgers and speculators to function properly.
Hedgers may include producers, portfolio managers and consumers. For example, if a farmer produces corn and is concerned about the per-bushel price of corn falling and thus reducing his potential profit, he or she could sell futures contracts. If a corn farmer sold a futures contract today for delivery in five months at a price of $4.00 per bushel, then if the price of corn falls between now and the delivery date the farmer would lose money on his cash crop but would be offsetting those losses by gains made on the sale of the futures contract.
In other words, if Farmer Joe sold corn futures at $4.00 per bushel and corn prices drop to $3.50 per bushel, the Farmer Joe would have a $.50 profit on each corn future sold that would offset the $.50 loss he is seeing on his corn. By doing this, Farmer Joe has insulated himself from a large drop in the price of corn that could adversely affect his potential income.
On the flip side, however, if farmer Joe sells corn futures contracts at $4.00 per bushel and the price of corn rises to $4.50 per bushel, then Joe will be getting more money for his corn crop but will be losing money on the short futures contract. Hedgers must accept this potential profit loss in order to lock in future prices. The bottom line is that many producers and consumers will give up the potential for additional profit in order to try and protect themselves from the potential for loss. This is how futures contracts may be used to try and mitigate price risk.
A gold futures contract is for the purchase or sale of 100 troy ounces of .995 minimum percent fine gold. A silver futures contract is for the purchase or sale of 5000 troy ounces of .999 percent minimum fine silver. At today’s prices, therefore, a gold futures contract would be worth approximately $130,300 with gold currently trading at $1,303 per ounce. A silver futures contract would have a value of $103,150 with silver currently trading at $20.63 per ounce. Needless to say, the total contract value will fluctuate as gold and silver prices move up or down.
With a gold or silver futures contract, he or she is entering into an agreement through an exchange to buy or sell the metal at a certain date in the future. The most recognized exchange when it comes to metals trading is the COMEX exchange which is now part of Chicago’s CME Group. To buy or sell a futures contract, one does not need to have the entire amount of the contract value but rather must put up what is known as a margin deposit. A margin deposit is a good-faith deposit to make good on the contract.
The fact that futures contracts only require a small portion of the contract value makes them a leveraged instrument. For example, if a gold contract has a total value of approximately $130,000 at current prices, only a small deposit of about $5940 is needed to buy or sell the contract. In other words, one can control $130,000 worth of gold for less than $6000. This may potentially allow some investors to make a significant return on their investment, but also may cause large losses.
Due to the nature of these vehicles, one’s losses can exceed their account equity. Leverage is a double-edged sword and is not suitable for all investors. Speculators may use these contracts to try and profit from price movement in gold or silver while hedgers may use them to try and mitigate price risk. While you can take physical delivery on a gold or silver futures contract, most futures contracts these days are closed prior to expiration or are cash-settled.
This is kind of a tricky question to answer. When purchasing a gold futures contract, you can take delivery on that contract of the physical gold. This process can be lengthy and somewhat complicated, however. One does not have the physical gold in their possession until they take delivery and even then the gold will likely be held in a depository until it is transferred to the location of their choice. Most futures contracts are never delivered upon, and gold and silver are no exception. When looking to buy physical gold, there are easier ways to purchase physical metal.
Why would someone sell a futures contract rather than buy it?
Futures contracts can allow one to potentially capitalize on price movements in the market. The reasons for someone selling a futures contract rather than buying could be they believe that prices are going to come down, or they could be a producer looking to try to hedge their price risk. For example, a jewelry maker whose potential profit may be hurt by falling gold prices could decide to sell gold futures in order to try to mitigate this risk.
Are Gold and Silver Futures Risky?
Trading gold and silver futures contracts involves substantial risk — and trading any futures contract involves substantial risk for that matter. Because of the leveraged nature of these types of investment vehicles, investors have the potential to make large profits but also have the equal potential to suffer large losses. In fact, due to the leverage involved, he or she can lose all of the funds in their account very quickly. One can lose more than all of the funds in his or her account as well. Trading in gold or silver futures contracts is not the same as owning the physical metal that one can wrap their hands around.
Would I be better off trying to time the gold or silver markets and trading them accordingly?
The fact of the matter is that the vast majority of investors are poor market timers. Think of how many professionals are out there today trying to “beat the market.” The majority of these professionals cannot beat the benchmark SP500 index. We are not saying it cannot be done, but for most people we believe this type of mentality is not going to be of benefit. That being said, paper investments such as futures, ETFs or the like do not equal physical metal ownership and do not accomplish the same goals.
What about the gold and silver ratio? Can it be helpful?
The gold and silver ratio is simply the number of ounces of silver that equals the value of one ounce of gold. So, with gold trading at $1,310 per ounce and silver trading at $20.05 per ounce, the gold/silver ratio would be 65.34. Some precious metals investors do monitor this ratio in order to try to get some type of buying advantage. For example, if the price of silver is low relative to the price of gold, one may buy silver coins, rounds or bars rather than gold. On the other hand, if the price of silver is relatively expensive to gold, then one may elect to purchase gold coins or bars. It is simply another tool that attempts to determine relative value.
Is it easier to take delivery of a futures contract rather than buying gold or silver from a dealer?
No. Taking delivery from an exchange on “good delivery” gold or silver is neither a simple nor a cost-efficient process. There are several hoops that must be jumped through in order to do this and in addition to those hoops there are fees and costs involved, as well.
What about hedging my physical metals with futures?
One of the biggest uses of futures contracts is for hedging purposes. Hedging involves the purchase or sale of a contract that can potentially help offset losses in a physical market. For example, if a jeweler is worried about the price of silver going up dramatically and squeezing his or her profits, they could buy a silver futures contract to try to help mitigate this risk. If the price of silver does, in fact, start to rise, then the jeweler would potentially see gains on the long futures contract that may help offset losses he or she is seeing on their profits due to higher silver prices.
Is hedging appropriate for the average physical metals investor out there?
This is very debatable, but, again, due to the nature of futures contracts they are certainly not suitable for all investors. Proper hedging requires a good deal of market knowledge and expertise and is beyond the normal investor’s investment acumen. In addition, if one is buying gold or silver for the long-term, they should be prepared for and accept any declines in prices that may occur.
Why do gold and silver futures move around so much?
Gold and silver are very active, and global markets trade nearly around the clock now. These markets can potentially be affected by many different things such as geopolitical events, central bank action or commentary, outside markets, such as oil or the dollar, and investor risk appetite. The markets are basically in a constant state of price discovery and, therefore, may have periods of quiet price activity and may have periods of very heavy price activity.
Do I need to monitor gold and silver futures prices every day if I own the metals?
This is totally up to you. We believe that physical gold or silver ownership is a long term investment and should be treated accordingly. The markets will have day to day or even second to second fluctuations in price. If you are looking at a long term time horizon, then these fluctuations are not too important in the grand scheme of things. That being said, you can monitor the price of metals on a daily basis if you so choose. The web is full of free resources to follow or track commodity or market prices, including on our gold price and silver price charts.