Friday, December 15

Should You Trade Gold Futures?

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Quick answer: Probably not. But let’s put the pros and cons under the microscope.

The gold market can be played in a number of ways. You can buy gold bullion bars or coins. You can buy shares in gold funds – including exchange-traded funds (ETFs). There are gold mining and processing stocks which benefit to varying degrees from higher gold prices. And there are other forms of “paper” ownership of gold.

A commodity futures contract is one form of paper ownership. Gold futures offer some distinct advantages for certain traders. Storage, insurance and transportation of the physical metal don’t drive up costs – because normally there is no physical metal. No metal also means no counterparty risk due to loss or counterfeiting. Think the price will fall? It’s easy to go short and profit if the price drops. Compared to physical metals, futures trading can be a quick and easy proposition.

But futures markets also come with some serious disadvantages.

Leverage   Futures are highly leveraged. That means that you only have to put up a fraction of a contract’s value – the margin – to “own” it.  Currently, you can control 100 ounces of gold, worth about $140,000, with only $6700 cash. But it would only take a 5% move against your position to wipe out your entire margin.  This loss of margin due to leverage is often attributed to the unusual volatility of futures prices. Futures prices are not more volatile – it’s the leverage that kills.

You’re David; They’re Goliath  The futures markets exist to hedge price risk. Any large gold owner can protect the value of their holdings by going short in the futures markets. These hedgers and producers of gold tend to be the larger players in the futures markets – and they tend to less leveraged and therefore stronger than the small speculator – you. Market power can be a decisive factor; especially when trading short term.

Commissions Add Up   While you can avoid certain fees by not dealing in physical gold, there are commissions and fees necessary to clear futures trades. Because futures contracts typically expire every month or two, they must be rolled regularly- thus incurring more commission expense. Any savings due to lack of storage costs can be easily lost by the need to continuously roll your position.

Speculation in gold futures is a highly leveraged trade – not an investment in gold or gold ownership. Futures are primarily designed for hedging and quick speculation. Understanding the difference can save you money.

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