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Futures

Futures contracts are another financial instrument that can be used to invest in gold. Futures contracts are an agreement to exchange a specific asset (like gold, currency or stock market index) for a price set today on a specific day in the future. The party obliged to buy the instrument that contract is based on is said to have taken a long position. The other party, obliged to sell, is said to have taken a short position. This exchange, in contrast to options, is compulsory.

Investors who buy futures contracts usually receive neither physical gold nor its monetary value. The only thing they receive is the difference between the initial price and the price at contract expiration.

In order to reduce credit risk both parties must place a certain amount of money to the exchange, known as a margin. It is usually 5-15% of the contract value. For example, in the New York-based Commodities Exchange (COMEX) it is $10,125 dollars for 100 troy ounces of gold. This margin gives futures investors leverage, since they put aside only a fraction of the contract value.

Futures can be used in many ways. They can be used to hedge against price (e.g. gold price) fluctuations or as a tool for speculation. It is, however, not advisable to use them as a long-term investment, since many factors influence their prices, like expiration dates of other contracts or the high volatility of the instrument they are based on (in our case gold). One can also lose all the invested capital if prices go in an unanticipated direction or there’s a lot of turbulence in the financial markets.

The first futures contracts on gold were introduced in 1974 in the United States when the then 41-year-old ban on possessing gold by private persons was lifted.

Futures contract are a very liquid instrument. They can be bought or sold almost any time. They are traded on exchanges and can also be accessed through the internet. That makes them a really useful tool for active investors and traders. According to the Chicago Mercantile Exchange daily turnover of the futures contracts on gold equals almost 20 million troy ounces.

The leverage offered by futures can be considered an advantage, but it may be a drawback. Rising gold prices (or prices of any other instrument a contract is based on) cause the contract value to rise much more. The same takes place when gold prices decline – they make the contract value decrease several times more.

What is more, falling gold prices mean that the value of margin also decreases. The investor has to deposit additional money in order to increase margin value and maintain the contract. If he doesn’t have a sufficient amount of money, he can sell the contract. Since investing in futures involves financial leverage it means that one can lose much more than they initially invested (or the initial margin value).

One of the main advantages of futures contracts is that they can be used to hedge against unfavorable changes of base instrument prices (like the prices of gold). It helps investors reduce risk and secure future profits. Contrary to buying gold in physical form, investing in futures contracts can also produce profits when gold prices decline.

However, the precious metals market is very volatile. This volatility can “push” investors out of the market if they do not have sufficient funds to deposit as a margin even if the long-term trend is rising.

Buying gold futures contracts also involves the risk that if there is a shortage of gold in the market or a serious financial crisis, futures trading may be restricted. It may prevent investors from buying or selling futures contracts and become sort of a trap for many of them. In the event of rising gold prices it may produce very large profits. Otherwise it may mean significant losses.

As mentioned earlier, some futures exchanges enable investors to exchange contracts for gold in physical form. This, however, can still involve some trouble, which investors using the COMEX experienced in 2009. Gold delivery had very serious delays and some investors received bars that did not meet the requirements stipulated in the contract in terms of weight or size.

Another risk is that the rules and regulations of the futures market can change. This is what happened in 2000 in the market for palladium futures. Margin value was increased to $168,750, from only $72,400 previously. In other words, one had to pay twice as much for the same contract. Effectively it meant reversing the leverage against investors, forcing them to close their positions. Furthermore, when investing in futures one has to take into account that the other party of the contract can default. Although margin plays the role of insurance against this and minimizes this risk, the risk of futures exchange bankruptcy can never be eliminated. What is worth mentioning is that futures are a zero-sum game – one person’s profit means an equal loss for the other. The futures market is very complicated and a lot of knowledge is required to succeed in it.

Futures contracts are traded on many exchanges. They can be found for example in the New York Mercantile Exchange (NYMEX, on the COMEX market) or in the Tokyo Commodity Exchange (TOCOM).

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Dear Sunshine Profits,

gold and silver investors MARCH 15TH, 2011
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