If you managed to get an idea about how derivatives are traded, you would have realised the potential for immense profits and losses by using these unique products.
But one fact that isn’t much of an open secret is that derivatives markets have widely become efficient ways to gain exposure to gold and other precious metals and has turned into the most cost-effective, in addition to providing great degrees of leverage and liquidity.
Gold and silver derivatives are financial instruments whose prices are derived from physical billions of the precious metals. The derivative itself is a contract between a buyer and a seller that wants exposure to the physical bullion’s price, while not physically owning the assets.
They have many useful applications, such as price discovery and price risk management, for those involved, especially in the physical bullion business.
- • Price discovery is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers;
- • Price risk is the possibility that commodity price changes will cause financial losses for the buyers or producers of a commodity and price risk management simply means mitigating or hedging the risk.
Analysts say rising popularity for gold or silver derivatives trading is a trend that will continue in the days ahead, so if you haven’t invested in gold or silver until now, this is an ideal time.
In recent times, they have become more important, given the recent spikes in gold price volatility driven by greater central bank interventions and heightened geopolitical risks. Analysts say this is a trend that will continue in the days ahead, so if you haven’t invested in gold or silver until now, this is an ideal time.
Let’s first brush through basics with some examples to understand the basics of derivatives trading of precious metals. For the ease of illustration, let’s talk about futures trading of silver.
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Let’s say a manufacturer of silver medals who has won a contract to provide silver medals for an upcoming sports event. The manufacturer will need 1,000 ounces of silver in six months to manufacture the required medals in time. He checks silver prices and sees that silver is trading today at $10 (Dh36.73) per ounce.
The manufacturer may not be able to purchase the silver today because he doesn’t have the money, he has problems with secure storage or other reasons. Naturally, he is worried about the possible rise in silver prices in the next six months. He wants to protect against any future price rise and wants to lock the purchase price to around $10.
The manufacturer can enter into a silver futures contract to solve some of his problems. The contract could be set to expire in six months and at that time guarantee the manufacturer the right to buy silver at $10.1 per ounce. Buying (taking the long position or bet on) a futures contract allows him to lock-in the future price.
(A long position—also known as simply long—is the buying of a stock, commodity, or currency with the expectation that it will rise in value; likewise, a short position refers to a trading technique in which an investor sells an asset with plans to buy it later.)
On the other hand, an owner of a silver mine expects 1,000 ounces of silver to be produced from her mine in six months. She is worried about the price of silver declining (to below $10 an ounce). The silver mine owner can benefit by selling (taking a short position on) the above-mentioned silver futures contract available today at $10.1 (Dh37.1). It guarantees that she will have the ability to sell her silver at the set price.
Assume that both these participants enter into a silver futures contract with each other at a fixed price of $10.1 per ounce. In the above cases, both the buyer/seller achieves buying/selling silver at their desired price levels.
Most futures trading is intended for hedging purposes. Speculation and arbitrage are the other two trading activities which keep the silver futures trading liquid.
This is a typical example of hedging—achieving price protection and hence managing the risk using silver futures contracts. Most futures trading is intended for hedging purposes. Additionally, speculation and arbitrage are the other two trading activities which keep the silver futures trading liquid.
(Speculators take time-bound long/short positions in silver futures to benefit from expected price movements, while arbitrageurs attempt to capitalize on small price differences that exist in the markets for the short term.)
Is it better than investing in precious metals?
Let’s first look at the benefits of simply investing in precious metals
- Put up the full value of the investment up front
- Profit only when your investment rises in value
Now let’s compare each of these points with investing in precious metals by trading in derivatives.
- Gain exposure to the full value of your position with only a small deposit, via leverage
- Take a position (bet) on a fall in value as well as a rise (by using options, a topic we discussed).
How to buy gold or silver derivatives?
Now that you have decided to invest, let’s look at how to buy these financial instruments.
To buy gold or silver derivatives the first thing you need to do is open an account with a stock broker. You can do your research for one initially online and if your main focus is to be on gold then it is recommended that you look for one that either specializes in precious metals or at least has an in-house trader with experience of precious metals.
You also want to consider whether you prefer to trade yourself online or by calling your broker. If you prefer the latter you need to find a broker that has their own online trading platform.
First time investors in derivatives may find it better at least initially to call their broker and give them verbal instructions when opening or closing positions. This is where it would be beneficial to have an account with a broker with experience and expertise in precious metals.
Only traded on margin
Before we go any further and delve into what type of precious metals derivatives are there, we need to keep in mind that, derivatives trade on margin, which is the amount of borrowed money you use to pay for the commodity-linked derivative.
When you trade in derivative products, you are not required to pay the total value of your position up front. You are only required to deposit a fraction (called margin) of the value of the total purchase.
When you trade in derivative products, you are not required to pay the total value of your position up front. You are only required to deposit a fraction (called margin) of the value of the total purchase. This is called margin trading and results in a high leverage factor in derivative trades, i.e., with a small deposit, you are able to maintain a large outstanding position (explanation below).
But remember that while this leverage can increase return-on-investment, it also increases the chance for significant losses in the event of an adverse price movement in gold or silver.
But remember that while this leverage can increase return-on-investment, it also increases the chance for significant losses in the event of an adverse price movement in gold or silver.
Let’s make this clear with an example – An investor purchases 100 ounces of silver at Dh50 per ounce. He funds half the purchase price (Dh5,000) with his own money and the other half he buys on margin (or on loan), making his initial cash outlay (money spent) Dh2,500. After a year, the share price doubles to Dh100.
The investor sells his silver for Dh10,000 and pays back his broker the Dh2,500 he borrowed for the initial purchase. Ultimately, he triples his money, making Dh7,500 on a Dh2,500 investment. Had he purchased the same number of shares outright using his own money, he would only have doubled his money, from Dh2,500 to Dh5,000.
Understanding further about margin and leverage
Now that we have a general understanding there are points to keep in mind that will make the concept of leverage and margin clearer.
- In derivatives trading margin is the down payment usually lodged with an independent central clearer which protects the other party from your temptation to walk away. So if you deal gold futures you will be asked to pay margin, and depending on current market conditions it might be anything from 2 per cent to 20 per cent of the total value of what you dealt.
- Leverage comes later and it is closely related to margin. In other words, margin trading accounts are used to create leveraged trading, and the leverage describes the ratio of borrowed funds to the margin. For example, to open a Dh100,000 trade at a leverage of 10:1, a trader would need to commit Dh10,000 of their capital.
- Different trading platforms and markets offer a distinct set of rules and leverage rates. In the stock market, for example, 2:1 is a typical ratio, while futures contracts are often traded at a 15:1 leverage. In regards to Forex brokerages, margin trades are frequently leveraged at a 50:1 ratio and higher ratios are also possible. Leverage comes with interests (in most cases dynamic rates.
- Depending on current market conditions margin could be anything from 2 per cent to 20 per cent of the total value of what you deal in. For example, suppose you had Dh5,000 to invest. If you buy gold bullion and settle you can only buy Dh5,000 worth. But you can probably buy Dh100,000 of gold futures! That's because your margin on a $100,000 future will probably be about 5 per cent - i.e. Dh5,000.
- If the underlying price goes up 10 per cent you would make Dh500 from bullion, but Dh10,000 from gold futures.
- There is a flip side too. If the price of gold falls 10 per cent you'll lose just Dh500 with bullion, and your investment will be intact to earn you money if gold resumes its steady upwards trend.
- But the same 10 per cent fall will cost you Dh10,000 with futures, which is Dh5,000 more than you invested in the first place. In this situation, your broker will ask you to deposit the extra Dh5,000 as a margin top-up (this is because of additional margin call). If you refuse to top-up your margin you will be closed out by your broker, and your original Dh5,000 will be lost.
Types of Gold/Silver derivatives
While there are many types of derivatives, the most common ones include futures, forwards and options. These contracts often allows settlements in interests, dividends, as well as in-cash.
Gold or silver futures – A precious metals futures contract is a legally binding agreement for delivery of gold or silver at an agreed-upon price in the future. A futures exchange standardises the contracts as to the quantity, quality, time, and place of delivery. Only the price is variable.
Two different positions can be taken: a long (buy) position is an obligation to accept delivery of the physical metal, while a short (sell) position is the obligation to make delivery. The most popular gold contract traded in US dollars is the COMEX Gold Futures, which is used to manage cash market price risk.
In the UAE, popularly traded gold futures on the Dubai Gold and Commodities Exchange (DGCX) include recently-launched Shari’ah Compliant Spot Gold contract (DGSG), Shanghai Gold Futures and India Gold Quanto Futures. Common silver future contracts include India Silver Quanto Futures contract and Silver Futures contract.
Gold or silver forwards – Gold or silver forwards (forward contracts) work essentially like futures – the main difference is that they are not traded in organized markets, but rather over-the-counter. It means that forwards have credit risk (risk of default), as there is no clearing house.
Forwards are not standardized, but customized to meet the investors’ special needs. Therefore, a gold forward contract is a transaction in which two parties bilaterally agree on the purchase and sale of gold at a future date.
These contracts often contain terms that are party specific, that are difficult to transfer readily to other third parties – it makes them less transparent and liquid than futures traded in an open market. However, investors usually pay larger premiums for the privilege of customization. The majority of gold forwards are traded in the London gold market.
Gold or silver swaps – Gold or silver swaps are contracts where two sides of the deal agree to exchange cash flows, where one party agrees to exchange cash flows linked to prices of gold for a fixed cash flow – a detailed example below. A swap is usually used to hedge against the price volatility. They are non-standardized contracts that are, like forwards, traded over the counter.
Example to make swaps clearer
A man, let’s call him Rob, entered into a contract to pay a fixed rate of Dh500/ounce of gold. If at the time, the price of gold is Dh520/ounce, how much has Rob saved, given the contract is for 2000 ounces of gold?
Here we see that Rob wants to pay a fixed rate of Dh500/ounce of gold. At this point in time, the difference would be: Dh520/ounce – Dh500/ounce = Dh20/ounce. As per the swap contract, the other party, would pay Rob (2000 ounces x Dh20/ounce), which is Dh40,000.
This Dh40,000 would offset the increase in the price of gold paid by the Rob. If Rob had to pay Dh520/ounce for 2000 ounces of gold, this would cost them Dh1,040,000. However, due to the swap contract the net amount is: Dh1,040,000 – Dh40,000 = Dh1,000,000.
If the price had been – Dh500/ounce, Rob would have paid: – Dh500/ounce x 2000 ounces = Dh1,000,000. We can see that through the swap contract, Rob is able to ensure a price of Dh500/ounce for the specified 2000 ounces of gold.
Gold or silver options – The gold options contract is an agreement between two parties to facilitate a potential transaction on a quantity of gold. The contract lists a pre-set price, known as the ‘strike price’, and an expiration date (or maturity date).
A gold option is similar to a gold futures contract in that the price, the expiration date and the dollar amount are preset for both. However, with a futures contract, there is an obligation to uphold the agreement and either buy or sell, the agreed-upon quantity of gold at the agreed-upon price – whereas for options contract it isn’t obligatory.
Types of options contracts which are put options and call options
• Call options gives the holder the right, not the obligation, to buy a specific amount of gold or silver at the strike price until the expiration date. A call option becomes more valuable as the price of gold increases because they locked in a buy at a lower price.
When you buy the call, you have the right, but not the obligation, to purchase the gold. If you sell the call, you do not have a choice and must sell the gold at the predetermined price when the person holding the opposite side of the contracts demands delivery up to the expiration date.
• Put options gives the owner the right, but not the obligation, to sell a specific amount of gold or silver at the specified price until the expiration date. A put option becomes more valuable as the price of gold decreases because they locked in a sell at a higher price.
If you buy the put, you have the right, but not the obligation, to sell the gold. When you sell a put, you do not have a choice and must purchase the gold at the predetermined price from the person holding the opposite side of the contract.
If neither the holder of the call or put options exercise their rights, the contract will expire as worthless.
If neither the holder of the call or put options exercise their rights, the contract will expire as worthless.
Gold CFDs – An alternative is to use CFDs to gain leveraged exposure to precious metals. A gold CFD is a theoretical order to buy or sell a certain amount of gold, and the profit or loss on the CFD is determined by the change in price of the gold. As it is a derivative, you never have to deal with taking ownership of the metal, but you can enjoy all the profits as if you had.
The other advantage is that it costs you a fraction of the amount you would need to buy the gold, through leverage. Gold CFDs are amongst the most commonly traded and hence one of the most liquid commodities you can trade and the advantage of this is that the difference between the buy and sell price (spread) is smaller and you should be able to enter and exit positions easily irrespective of the size. But keep in mind that gold is a volatile market and at an average goes up or down $40 (Dh146.92) (or 400-point moves) in a trading day.
How you can benefit from investing in precious metals using derivatives?
Highly liquid – Most gold derivatives are highly liquid trading instruments that are easily accessible electronically or with a phone call at any time of the day. Transaction costs are low and investors can tailor leverage according to their risk appetite.
Leverage – Financial leverage, as discussed earlier, is the use of debt to secure additional assets. In many ways, leverage is the backbone of the global derivatives markets. Market participants depend on the extension of credit to buy and sell financial instruments via the mechanism of margin trading (explained at the start).
Although there are certainly very real dangers to leverage, the potential upside often outweighs the assumed risk. The main benefit of leverage is the ability to control a large contract value with a relatively small amount of capital, meaning with leverage investors can turn a small amount into a huge sum – or into nothing.
Hedging benefit – Gold mining companies have turned increasingly to derivatives to lock in future revenues. Hedging, like the example given at the start, allows miners to lock in the price of their output. This offers protection from falling gold prices, but means they can lose out if prices rise sharply.
Profit from falling markets – Unlike investing in gold, when you trade gold or silver using derivatives, downturns and declining markets offer great opportunities for profit because derivative products will enable you to speculate on not just rising, but also falling markets.
Risks of trading precious metals through derivatives
Leverage risks – The potential reward and the risk of precious metal derivatives come from the same reason. These investments can be highly leveraged. Like for example, when the price of gold moves in the direction the investor in gold derivatives hopes there can be substantial profits. When the gold market moves in the contrary direction the investor may see his or her investment capital evaporate.
Dependent on value – When the value of the underlying metal, falls, owners of the metal’s derivative investments can see the value of their investments decrease rapidly. Traders in gold futures could see their margin (borrowed money) deplete, leaving them with the choice of adding more money to maintain the investment position (margin call) and staying with a sinking investment or losing their investment capital.
In cases where there is a rapid drop in prices investors in some forms of derivatives often find no buyers for their contracts and can be financially ruined in an afternoon.
Gold quadrupled in price over the last decade. Gold also went up and down along the way.
Volatility risks – Gold quadrupled in price over the last decade. Gold also went up and down along the way. This sort of volatility is why many investors buy debt-free, physical precious metal assets. Those with physical gold never saw their wealth disappear and, with time, profited very well from the rise of gold prices.
Owning physical gold or silver protects the investor from ten or twenty per cent yearly fluctuations in the gold market. The risk of gold derivatives is that a twenty per cent chance in price may be disastrous.
Platforms, tools to trade gold/silver derivatives
Dubai Gold and Commodities Exchange is the largest derivatives exchange in the Middle East. Different products you can trade in include Gold Futures Contract, Gold Options on Futures, Silver Futures, Steel Rebar Futures.
DGCX partnered with trading platform Cinnober for investors to make trades, which have become an increasingly popular option. The trading platform allows for the entering of orders and trades, allowing users the ability to amend/cancel their orders as appropriate. You can also trade Gold CFDs on popular well-established platforms such as IG, Plus500, FXTM, eToro or NBH markets.
