Although gold has been a tradable asset since only 1971, following President Richard Nixon’s taking the Unites States off the gold standard, it and other metals now are a large portion of many traders’ portfolios. A look at average daily volumes in gold futures contracts traded at CME Group over the last 10 years shows that growth in interest (see “Gaining popularity,” below).
Now, 40 years after becoming a tradable asset, gold and other metals can be accessed in a number of ways, including traditional physical holdings, futures contracts, exchange-traded funds (ETFs) and through correlated markets such as mining stocks. Each vehicle has its own advantages and disadvantages, but with so many options available, investors of all types should be able to find a product to match their temperament.
Before discussing each of the specific investment vehicles, David Meger, director of metals trading at Vision Financial Markets, reminds that, “No one vehicle is necessarily better than the others. It’s all about what the comfort level of the client is, what the client is acclimated to trading and just what it is they are looking for. We can draw out the plusses and minuses of each, but at the end of the day, they’re each relatively similar.”
Physical holdings
The most straightforward way of accessing metals is to buy and physically hold the actual metal in bars or coins. Stephen Platt, senior account executive at Archer Financial Services, says one of the main draws of physical holdings is security. “You actually have the metal and a lot of people feel more secure holding the actual gold,” he says.
Bill Downey, analyst at GoldTrends.net, explains that people holding gold for security reasons generally hold it for its ability to retain long-term purchasing power and as insurance in case of an unforeseen event.
In addition to security and purchasing power, Platt says some people purchase physical gold as a way of transferring wealth in terms of giving it as a gift.
On the down side, Downey says people with physical holdings have to worry about liquidity. “If you are going to be trying to move product on a sharp downtrend, you’re not going to get good prices for it,” he says.
Trying to liquidate physical holdings quickly can be more difficult if you remove the metal from an approved warehouse because it may need to be reassessed before you can sell it. Storing metal in a warehouse necessitates a nominal storage fee, though. And possession is nine tenths of the law, as former MF Global customers learned when a bankruptcy trustee laid claim to their physical holdings in warehouses.
Ultimately, Downey says that generally physical holdings should be considered a longer-term investment because the lack of liquidity, storage fees and higher commissions can make them more difficult to trade on a shorter time horizon.
Futures
Futures contracts on metals offer the benefits of leverage and a lot of the same advantages of physical holdings because if a buyer holds the contract until expiration, he takes delivery of the metal. However, he then has to pay the full cost for 100 oz. of gold instead of margin, which usually is between 5% and 10%.
Meger says the futures markets have a number of advantages going for them. “No. 1 is liquidity and the ease of entering and exiting the market. With the futures market, you’re talking about a nearly 24-hour trading platform with great liquidity. Add on top of that the ability to use leverage,” he says.
Additionally, the futures markets tend to be better regulated than the physical marketplace. “It’s a regulated industry vs. an unregulated industry,” Platt says. “When dealing in the futures industry, there is a lot of regulation between the [Commodity Futures Trading Commission] and the [National Futures Association]. When you get into the cash market, there are a lot more grey areas that [can lead] to more risk.”
Whereas physical holdings require an investor to purchase the metal at full price, leverage in the futures market allows an investor to deposit a smaller margin amount to control a much larger position. For the full-size 100 oz. gold contract at CME Group, an initial deposit of $10,125 is all that is needed to buy or sell a single contract.
Leverage can be both a positive and a negative because it amplifies any gains or losses in a position. “You do not have to use leverage in the futures market, but the futures market affords someone the significant use of leverage,” Meger says.
Downey explains, “The ranges have expanded now that it’s not $400 gold anymore. Where a 10% move used to be a $40 range, it now is a $150 range. People can get really hurt,” he says.
Ultimately, the leverage and liquidity avail the futures markets to the trading side of the market much more efficiently than the physical market. Downey warns that the ease of getting in and out of positions can be a downfall for some investors. “There are not a lot of people that have the discipline to buy a futures contract and sit and hold it because there is so much leverage involved and so many price swings,” he says. “What ends up happening, if you’re not disciplined, is you may find that by the end of the week you’ve traded it three times.”
Options on futures allow the same leverage benefits but enable users to better define their risk. Options may be a preferable and less risky way to access the market, but also are more complex and require more study to understand elements of volatility and how various strikes move.
ETFs
Metals-backed ETFs, like the SPDR Gold Shares (GLD), are relative newcomers to the trading party, only being launched in late 2004. “Gold always has been one of the bigger futures contracts. The securities world started metals ETFs to compete for the retail marketplace in metals,” says Kurt Johnson, president of Archer Financial Services.
ETFs have similar regulatory oversight as futures, according to Meger. “Generally speaking, you are not offered the same amount of potential leverage,” he says, adding, “The nice thing about the ETFs is your everyday, less sophisticated investor understands stocks and equities better than they do the futures market. It’s a more straight line buy or sell type trade with very [few] idiosyncrasies in it. There are minor fees that ETFs charge, but that isn’t a significant barrier to trade.”
ETFs are securities, so you can access metal ETFs through a securities account without opening a futures account.
Although futures allow an investor to take physical delivery at contract expiration, that option does not exist in the ETF structure. “An ETF is a paper transaction, and it always will be. A futures contract is a paper transaction that can be converted into physical,” Platt says.
That ability to buy and hold without having to roll when contract months expire makes them a good option for short- and medium-term investors, Downey says. He cautions, though, to know what you are trading because some ETFs are double or triple price points.
Mining stocks
Finally, some investors may look to mining company stocks.
Although there is some correlation between a mining company’s stock price and the underlying metals, Meger cautions that it is not a true metals play. “You’re really trading a number of other factors in the price of that particular equity as opposed to the underlying metal price. Those include the [management], whether that company hedges any of its forward production, the financials of that particular company, etc,” he says. “There are a lot of things standing between you and a pure play on a metal. It’s not a bad vehicle, but investors need to understand that it is not a pure metals play.”
Platt adds, “Because there are a number of factors involved, at times mining stocks can outpace a movement in the metals, but at other times they can undershoot.”
The bottom line is that the price of the underlying product is just one fundamental in examining a mining or any other company, so if you have an opinion on a miner, trade the stock, but if you want to trade an opinion on gold, wheat or copper, trade the commodity or ETF based on it.
Now there are more ways of accessing metals than ever before. With so many options available, there likely is a vehicle available for nearly any type of investor. Before you jump into a trade, though, Meger offers three criteria every trader should consider: “[Know] your time horizon, your expectations for the investment and the costs.”
