From the May 01, 2012 issue of Futures Magazine • Subscribe!

Getting started in metals

Trading 101

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. 

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