Understanding Gold Futures

A gold future is essentially a contract that is traded on an exchange. By purchasing this contract the buyer is agreeing to take delivery of a specific quantity of gold at a predetermined price and on a predetermined date. It is basically a marketplace in which precious metal buyers and sellers can speculate on the future price of gold, and it is popular with bullion dealers, jewelers and with mining companies, as well as regular traders.

To better understand how these futures work, we can use a gold mine as an example. There are many costs associated with mining gold, and if the price of gold plummets in the future, then it may be forced to sell for a minimal profit, or for no profit at all. To guard against this, the gold mine can buy a contract at a specific price, known as a “short” position. Therefore, if the price does drop and it is forced to take a loss, it will still have this contract (set at the previous price), and the profit from that will help it to offset its losses. Conversely, if the price of gold increases then it will lose money on this contract, but that balance will be offset by the production profits.

Futures are traded in margins, which essentially means that you do not need to pay the full price of the gold that you are trading. A margin is the amount of money that you pay in order to control a futures contract, and the rate of these margins is set by the futures exchange. A margin is a frac-tion of the price of the gold you are purchasing, often set at around 5%.

A gold price of $1,200 an ounce would translate into a price of $120,000 for 100 ounces on the COMEX. The margin for this contract would be just $4,000, which means that you can control $120,000 worth of gold for just $4,000, at a leverage of 1:30.

Understanding Margins

Let’s assume that you have $100,000 and want to invest in gold. If you invest in the futures market you may only need to pay $5,000 upfront, but that doesn’t mean that you won’t need to come up with anymore money. If the price of gold increases after purchase, then you will earn a profit and this will be paid into your account. If it drops, then the difference will be removed from your ac-count.

In the above example, you would only need the price of gold to increase by a small amount for you to double your money, but if it decreased by a small amount then you would be required to put up another $5,000 to keep your contract. If not, then it would be liquidated or sold. If you pay a further $95,000 upon receiving a delivery notice, then you can also take delivery of your gold.

Key Terms:

  •     Short: An agreement to sell in the future.
  •     Naked Short: An agreement to sell that is not backed up by actual gold.
  •     Long: An agreement to buy in the future.
  •     Position Limits: The maximum number of contracts you can own at any given time.
  •     Delivery Notice: If a “short” seller does not close out their position by offsetting with a “long” position, then they will be required to arrange delivery of the contract.
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