Commodity Futures: Background for Gold Prices

This post is a background on on commodity futures, which include oil, wheat , gold etc to understand the difference between Physical Gold and Gold Futures prices.   It is a primer to understand the post on Gold: Buy or Sell and Price Calculator.

A future is basically locking in a price now to buy something in the future. There are two important aspects to the Futures Market.

• In the past futures market was physically settled.  
• Futures contracts are on Margin

Physically vs Cash Settled

•  If you bought a futures contract on oil and forgot to sell it off before settle day you could have a tanker load of oil on your hands.  Happened to one of my Trader bosses when he was a rookie trader.  
• If you sell the future, and dont getting around selling your contract before settlement day you would need to find an tanker full of oil to settle the contract

Now futures can be (and often are) cash settled. In the case of Gold very few want to be the sellers of a physically settled gold contract.  Thats because its harder to locate or want to sell  physical gold.

Margin

The basic idea is that you can enter into a futures contract with a percentage upfront.  So if you buy a contract that is worth $1,000 on the day you would need to put up $100 (10% margin).  There are other issues called maintenance Margins, which we wont get into.  As a buyer of the futures contract, if the price goes up to say $1,200 it does not matter or you can sell your contact and make a profit  of $200. 

Now the tricky part. Say half way before settle date the futures price drops to $750. You have a couple of options.

• a)You can either sell the contract and loose $250 which includes the $100 margin which you initially put up

If you want keep the contract you need to put up another $25 margin. You can look at the $25 margin in two ways,

• You are going to loose/pay $250 more and need to put up $25 i.e 10% of $250
• You owe the exchange 1,250, i.e a margin of $125 less the initial $100 is $25.  The $1,250 is  based on the 1,000 price you have contract to buy and the $250 you loose when you sell the contract at $750. 

So now that you understand Futures, you can understand how on May 12th 2013 the selling of gold futures would have have made the sellers of the futures, profits in one day.

The drop was because of 100 tonnes (about 15% of annual gold mine production) of gold futures was sold/dumped on Friday 12th*.    Futures sellers probably have already made their money when the prices dropped below their selling price.  You just buy Futures contracts at price below what you sold, cover the contract and out of the market.   All on margin,  i.e. a large profitable gamble

*Remember, this is not Physical gold you are selling, its paper/cash settled so you dont need to have 100 tonnes of Gold, just the margins in Cash.