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Capital Ideas: Gold Futures and Leverage Concepts

As noted by a Swiss Institute research paper, "the gold market of today is much different than the gold market of ten years ago." One example is securitization of commodities, a fairly recent innovation with the ETFS Physical Gold[1] being the first gold security traded in March 2003 on the Australian Securities Exchange (ASX). Soon thereafter, additional exchange traded gold securities were launched, including the first US-based gold ETF, SPDR Gold Trust formerly streetTRACKS Gold Shares (symbol: GLD).

Given gold ETFs popularity it is not surprising that individual investors have generally forgotten about the potential benefits of using gold futures. This article sets out to educate investors on such advantages. To begin with, while London continues to be one of the most liquid and influential markets by virtue of its twice-daily fixings in determining the spot gold price, the COMEX gold futures contract,[2] which began trading along-side the US physical market on December 31, 1974, has come to dominate the market in terms of volume.

There are many differences between gold futures and gold ETFs that make an "apple-to-apple" comparison difficult. ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be traded throughout the day -- but so can futures contracts. Rather, the intrinsic difference has to do with how investors view and trade these instruments. Futures are risk management tools, whereas securities are tied to the "rising tide raises all ships" concept of capital formation. Academics have also noted that commodities are not capital assets, but instead consumable/transformable assets. Gold as a commodity is considered even more unique given its legacy as a "store of value". But this is just theoretical discussion.

The main practical distinction between gold ETFs and gold futures has to do with the concept of leverage. Specifically, SPDR GLD represents approximately 1/10th the price of one ounce of gold (and thus one share represents approximately 1/10th of one ounce), whereas the COMEX futures contract (symbol: GC) is priced in ounces but each contract represents a 100 ounces. For example, the NAV per share of GLD was initially priced on November 18, 2004 at $44.20 or $442/ounce. Alternatively, GC at $442/ounce is equal to $44,200. So in order to have the same exposure as one futures contract, an investor at initial offering would have had to purchase 1000 shares of GLD and invest $44,200. When the GLD ETF was launched, a futures trader on the other hand would have been required to put up just $2,500 for one contract at that price/face value.

Before going further with our discussion, it is appropriate to remind readers that leverage may work against you as well as for you. In fact, what makes futures trading difficult for so many novices is its high degree of leverage -- any market movement can have a disproportional and amplified effect on your deposited funds.

It is also important to remember that the definition of margin for securities is a very different concept than that in the futures markets. Most investors think in terms of "Reg T" requirements in which one may borrow up to 50% of the purchase price of securities. Since this is effectively a loan, the broker charges interest for the money it lends its customers to purchase securities on margin. For more detailed information on securities margin, FINRA provides an educational forum to help investors better understand these markets.

Margin requirements for futures, on the other hand, are akin to a "good faith deposit" which can be as low as 2-3% of the contract's nominal face value. For example, let's assume that the initial margin requirement for gold is currently $5,750 and that the June gold contract settled end-of-month in April at 1180.70/ounce. Since one gold futures contract is equal to 100 ounces, the "nominal face value" of the contract is worth $118,070. The initial margin-to-face value then is approximately 4.9%. It should be noted that while minimum margin requirements are set by the exchange on which the contract is traded, individual brokerage firms may require higher margin amounts from their customers than the exchange-set minimums.

This relationship between margin requirement and the nominal face value of a futures contract constitutes leverage. Leverage allows traders the potential to produce high returns as well as large losses. In practice, however, experienced traders will typically allocate more funds than the minimum amount needed to trade in order to provide themselves with a buffer in case a trade goes against them.

The discussion so far serves as background to the concept of notional funding and investing in managed futures. Managed futures is a niche sector of alternative investments, and refers to professionally managed assets in the commodity and financial futures markets. Management is facilitated by either commodity trading advisors (CTAs) or commodity pool operators (CPOs) who are regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

When professional futures traders design a trading program, they usually establish a baseline account level which determines the type and number of contracts that will be traded given the baseline "unit size". The average aggregate margin requirement for the trading program is then divided into the account level in order to determine the average margin-to-equity ratio. The next paragraph describes how this works.

Let's imagine that a CTA has developed a trading program which trades one gold contract and collars the position with one call option and one put option. While gold's face value as of this writing is $118,000, the minimum investment or account size is $50,000. At the same time, the CTA's typical position requires an initial margin of only $2,500. This results in a margin-to-equity ratio of just 5%. Allowing for drawdowns[3] due to potential trading losses, an aggressive customer could in practice invest just $25,000 to fund the account. This amount is gauged by the CTA as sufficient to trade the program, even if drawdowns should occur.

This difference between the actual cash deposited in the trading account and the account size is called notional funding. And while the CTA will continue calculating the program's rate of return based on the $50,000 trading level, the investor's actual return is a function of the $25,000 funding level.[4] Likewise, a 1% return on $50,000 is equivalent to a 20% return based on the $2,500 margin required for the position.

Again, it is important to note the possibility that an investor could sustain a loss of some or all of the funds deposited. In such a case, the investor not the CTA will receive the margin call from his/her broker. As a standard industry practice professional futures traders maintain a close watch on their margin utilization. Likewise, futures brokers typically retain the right to close out open positions if an investor is unable to meet margin calls. Also be advised that margins are subject to change, especially in times of volatility.

Now on to our monthly market/trading recap: Gold plunged in the latter half of March forcing us to get defensive a few days prior to option expiration. The 1095 strike we established on the May contract was intended to manage downside risk, but the subsequent rally, which likely started as short covering, quickly ascended to the top of the current range. At that juncture rolling up the strike price mid-cycle became a question of risk management. We decided play it prudent and not roll the contract immediately, whereas in hindsight we could have done so earlier. Regardless, we still booked another positive monthly return, although admittedly we were outpaced by the gold ETF for the first time since November last year.

Our mid-month article is going to review research from that Swiss Finance Institute paper mentioned above. The paper analyzes the central bank gold leasing market, the gold forward offered rate (GOFO) and derived lease rates. As we cycle into the month of June, we will further examine the COMEX gold futures contract including details on contract specifications, settlement and delivery.

 

Footnotes:
[1] Issued by ETFS Metal Securities Australia Ltd., a wholly owned subsidiary of ETF Securities Ltd.

[2] The Commodity Exchange (COMEX) was established in 1933 through the merger of four smaller exchanges. On August 3, 1994, the New York Mercantile Exchange (NYMEX) and COMEX merged under NYMEX Holdings, Inc. On August 22, 2008, CME Group Inc. completed an acquisition of NYMEX Holdings, Inc. The COMEX is now part of the CME Group.

[3] "Drawdowns" is a term frequently used in the managed futures industry to describe the negative rate of return measured from a CTA's peak performance. Effectively, it is a measurement of risk for CTAs.

[4] Unlike securities, since margin for futures trading is a "good faith deposit," an investor can invest his money in a fungible instrument such as T-bills, which then collateralize the futures account. For more information on how this works, contact your futures broker.

For more information contact: Capital Trading Group

 

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