Hedging Strategies With Gold Derivatives

By: Jonathan Chan Phillip Futures.

Gold Derivatives

Gold derivatives are financial instruments which have their prices derived from physical gold. The gold derivative itself is a contract between buyer and seller who want to take exposure on the physical gold price. They have many useful applications like price discovery and price risk management for those involved in the physical bullion business. In recent times, these have become of increasing importance given the recent spikes in gold price volatility driven by greater central bank interventions and the heightened geopolitical risks. This is a scenario which we may continue to see in the days ahead.

GVX (CBOE/COMEX Annualised Gold Volatility Index)

Types of Gold Derivatives:

Gold Futures

Gold futures are financial contracts obligating the buyer to purchase gold or the seller to sell gold at a predetermined future date and price. Having future settlement dates means that future selling price and buying price of your physical inventory for your business can be hedged accordingly if you are of the view that prices may move against your favour. Future prices are expected to converge to the spot prices on the day the future contracts expire, hence they are price efficient. These futures contracts are standardized to facilitate trading on a futures exchange with quality and quantity of the gold specifically detailed. The advantage of using exchange-traded futures product is that counterparty credit risk is almost close to negligible as the derivative exchange will facilitate the transaction, settlement and collateral management of the traded contract. The most popular gold contract traded in the US Dollar is the COMEX Gold Futures which have been used to manage cash market price risk.

Hedging allows gold fabricators and dealers to lock in prices and reduces exposure to price risk. A gold smelting company wishes to manage the input cost and decides to long gold futures to hedge against any upward movement in the cost of their gold inputs beyond US$1,270/Oz. This long hedge would establish a fixed cost for raw material. The combined payoff diagram of buying futures is shown below:

If gold prices rise, the smelter would be protected by the rise in value of the futures contract whilst a fall in gold prices would be a loss but the smelter would be able to buy raw material at a lower cost. Thus, on the whole, this hedge would enable the smelter to work out a fixed price for raw material.

Spot Gold Over-The-Counter (OTC) Contracts

The Spot gold OTC price is the current price of a troy per ounce of gold that can be bought or sold for immediate cash settlement. It is also broadly known as the Loco London Spot. Trading is usually done directly between two parties involved. OTC markets trade round the clock with trading done electronically or by telephone. There is no formal structure or centralised clearing thru an exchange. Prices are usually quoted and traded against the US Dollar. Generally positions are maintained over time without any concerns over maturity. Each contract is has a size of 100 ounces with a minimum bid unit of US$ 0.1 per troy ounce. Over the years this contract has served market participants well, it has been used by gold bullion dealers to hedge their physical inventory against fluctuating prices whilst allowing speculators to move in and out of the spot market with ease, yet still enabling investors to hold on to their positions for a long period of time without concern about maturity or delivery of physical gold.

Spot Low Leveraged Gold Contracts

However, for those who are more risk-adverse and do not prefer the high leverage of Loco London spot, can trade the Gold Direct Investment (GDI) which is the one of the newer low leveraged gold derivative in the market. It has a higher relatively margin collateral as compared to Spot Gold which however virtually eliminates the risk of a margin call. It is designed as an affordable investment product with a contract size of a troy ounce of Gold with a fineness of 995. Although the collateral needed to trade the GDI is only slightly less than the cost of a gold ETF or physical gold, it allows participants to short sell as well, unlike ETFs, and has no storage cost as compared to physical gold.

Gold Options

Gold options are financial derivatives whose pricing is intrinsically linked to the price of Gold. These derivatives are contracts that grant the right, but not the obligation to buy or sell the underlying gold asset on or before a certain date. A Call option is the right to buy and a Put Option is the right to sell. The option buyer would have to pay the seller an option premium to complete the transaction. Intrinsically, owning a call option gives you a long position in the market and for the seller of a call option a short position. Inversely owning a put option gives one a short position and selling a put is a long position.

Advantages of options over futures are the smaller cash outlay required and the greater flexibility in selecting the price at which you would like to hedge from. When buying options, you are only required to pay the option premium which represents a small percentage of the notional to be hedged. For options, you have the advantage of selecting the price at which you would like to hedge your physical gold position against, while for futures, you can only accept the price that is quoted by the market at any point of time.

Options are often used by miners wanting to lock-in and secure a minimal selling price. Miner X wishing to secure US$1,240/Oz for their gold production in the month of October 2017 would buy gold put options to hedge against any downward price risk. With Spot gold trading currently at US$1,255/Oz, the cost or premium of put options with a strike of USD 1,240 is US$0.24/Oz. The combined production and put options payoff diagram is shown below:

The Put Options thus permitted the miner to cover the forward risk of falling prices and his hedge enabled him to carry his inventory until October2017. If gold prices do fall, the mining company would have minimised their loss due to the protective cover of the options.

Advantages of Gold Derivatives?

Most gold derivatives especially Loco London Spot Gold are highly liquid trading instruments which are easily accessible electronically or just by a phone call every business day or night. Transaction costs are low and one can tailor leverage according one’s risk appetite. Gold is also priced in multiple currencies which allows for arbitrage opportunities for savvy traders. As a result of the fluctuation in the USD/JPY currency pair, Gold is often mispriced in Japan as compared to the USA and traders would utilise gold futures traded on TOCOM and COMEX to profit from this gold price anomaly.

RISK DISCLAIMER: Trading in futures products entails significant risks of loss which must be understood prior to trading and may not be appropriate for all investors. Past performance of actual trades or strategies cited herein is not necessarily indicative of future performance. The information contained herein is provided to you for information only and believed to be drawn from reliable sources but cannot be guaranteed; Phillip Capital Inc. assumes no responsibility for errors or omissions. The views and opinions expressed in this letter are those of the author and do not reflect the views of Phillip Capital Inc. or its staff.