By Peter Schiff
I’ve been emphasizing for months that the current correction in the gold price is a result of speculative money fleeing the market and not any reflection of gold’s long-term fundamentals.
Unfortunately, there is so much money to be made (and lost) by day trading that my cautions have once again fallen on deaf ears.
Well, it looks like the so-called “technicals” are starting to support my theory, and so this month I’m going to depart from my typical discussion of market fundamentals and take a look at the COMEX gold futures market.
It turns out that the same paper markets that helped drive the price of gold down are beginning to run into the hard reality of physical gold demand; their reversal may push gold to new highs.
Reading the Futures
The world of futures contracts is often confusing for ordinary investors. It is mainly the domain of institutions seeking to hedge and professional speculators. I do not recommend passive investors get involved in futures trading, but it is helpful to understand how these financial instruments affect gold’s spot price.
In its most basic form, a gold futures contract is an agreement to buy a set amount of gold at the current spot price with delivery guaranteed at a future date. The attractive part is that you don’t need to pay the full price up front.
You can put a down payment on 100 ounces of gold today, knowing that you will only have to complete the payment when the contract comes due. If the price of gold rises in the intervening time, you’ve made a nice profit, because you end up paying today’s price for a product that is worth more in the future.
Of course, the person who sold you the contract takes a loss for the same reason. The person buying the contract is said to be “long” gold, while the seller is “short.”
One of the reasons gold futures are so risky is because of the sheer quantity of gold that transactions represent. When you buy a single COMEX gold futures contract, you gain control – and responsibility for – 100 troy ounces of the yellow metal. So when the gold futures market was said to have made “big moves” this last April, that was an understatement – on April 12th, it opened with a sell off of 100 tons of gold!
It gets worse. Traders often leverage (borrow cash) to buy futures contracts, with the down payment they supply known as the “maintenance margin.” The minimum maintenance margin for a single futures contract is only $8,800.
If spot gold is at $1,300, then a trader can gain control of $130,000 worth of gold with less than 7% down! Depending on a combination of luck and experience, this massive leveraging can lead to either amazing profits or devastating losses.
Let’s walk through an example, keeping in mind that my figures are very simplified, because a futures contract is not exactly equal to 100 times the current gold spot price. Most of the time, futures prices are a little higher than spot gold.
Say gold is at $1,300, which means a COMEX gold futures contract gives the investor control of about $130,000 worth of gold. A trader buys a contract with only a $8,800 margin. If the price of gold goes up to $1,500, the futures contract is now worth $150,000. The trader can now sell that contract and pocket the difference.
He just netted about $20,000 with only $8,800 in seed money. If the trader had simply bought $8,800 worth of physical gold, he would have only earned about $1,350 in the same time period. It is not hard to see how futures trading can seem exciting and profitable on its face.
