Usually, in the media, only one value of gold is circulated that goes up or down. But, the precious metal has many values because it is traded in different markets, and knowing their dynamics is important not only for investors, but also for what is happening in the economy as a whole.
Although considered by some to be just an investment asset, gold has a number of other applications and does not have a single price. It is traded by different economic agents in several separate markets, which allows investors not only to profit from fluctuations in different segments, but also from the price discrepancy in different markets, which is called a spread.
The most important gold markets
Keith Winner, a veteran gold trader and president of the Gold Standard Institute, identified the three leading markets as:
- spot (at the London Metal Exchange);
- futures (at COMEX in New York);
- commercial gold – physical coins and bars.
Although influenced by different supply and demand, the difference between spot and futures prices is usually not large. For example, on October 12, 2020, the spot price in London was $1,922.55 per troy ounce, and gold for December delivery on the COMEX traded at $1,927.60 per troy ounce.
Gold spot and futures markets
A market in which futures contracts have a premium over (ie are more expensive than) the spot price is called the market. “A Guide to the London Bullion Market”, published by the London Bullion Market Association, explains why:
“Typically, the interest rate on gold is lower than the interest rate on the dollar. This makes the forward value of the metal positive, meaning it is higher than the spot price. In very rare cases, when there is a shortage of metal that can be used for leasing, the cost of borrowing gold can exceed the value of borrowing dollars. In this scenario, the forward differential becomes negative and the futures price is lower (in other words, there is a discount compared to the spot price), and the situation is called a downgrade.”
Another reason why futures contracts have a premium over the spot price is that of gold storage. When an investor buys the right to purchase an asset at some point in time, the gold has to be held somewhere until maturity. The cost of this service is also included in the futures price, making it more expensive than spot.
But regardless of whether we are dealing with a contango or backwardation market, the difference between the spot and futures price of gold generally remains small. The equilibrium tendency of the two values is not a coincidence or a consequence of the fact that the same commodity is being traded, but the result of the demand for profitability by traders and the economic law of supply and demand.
Arbitrage – corrector of gold price fluctuations
When the difference between the two types of prices increases (for example, the futures price rises significantly above the spot) market participants have an incentive to buy gold at the current value in London and sell it at the futures price in New York, for example. A transaction in which an asset is simultaneously bought in one market and sold in another is called an arbitrage.
But this cannot last forever. When such transactions take place, it increases the demand in a market where the value of the commodity is lower (in our case spot gold), but also the supply in the market where the price is higher (ie gold futures). Thus, the price premium is reduced, and at some point arbitrage will no longer be profitable.
The Covid19 crisis and the increase in the price gap
Arbitrage in both markets requires gold to be melted, as the London Metal Exchange and COMEX allow trading in different quantities, the standard being 400 troy ounces in London and 100 troy ounces in New York. This operation is usually cheap, but with the onset of the pandemic in the spring of 2020, the profile market faced an unexpected challenge. During the quarantine, many refineries shut down, and gold could no longer be smelted to previous standards.
Because of the general uncertainty, fund purchases and exchange-traded futures contracts rose sharply in the first phase, leading to massive appreciation in gold. Later, due to the blocking of arbitrage and the mutual influence of futures prices, the difference between futures and spot prices increased to 15% (about $70 per ounce).
Differences further faded in May 2020, following the resumption of Swiss refineries, which are an important player in the profile market. According to Commerzbank , they have the capacity to refine 1,500 tons of gold per year, an amount that represents approximately one third of the total amount of gold refined globally. Arbitrage was thus able to restore balance between spot and futures prices, directing gold from London to New York.
Thus, when the March and April futures contracts matured in July, increased demand for financial instruments led to the largest supply of gold in COMEX history, amounting to 3.27 million ounces, as the quantities of gold traded in general they are usually significantly smaller.
Futures and leverage
Leverage, also known as leverage, allows traders to enter into high-value trades with little upfront investment, making futures investing even more accessible to ordinary investors. With a leverage ratio of 20:1, for example, an investment of $1,000 can be worth $20,000. That makes the profit, but also the risks, much higher than the initial capital.
Futures leverage is also disproportionately affected by changes in the price of gold. Since the ratio of equity to leased capital is 1:20 per ounce, if it increases even by 1%, the actual effect on the investor will be equivalent to a 20% increase in value to him.
Here’s what leverage trading looks like. If the price of a troy ounce is $500 and the COMEX can trade a minimum of 100 troy ounces, and the leverage is 15:1, then the investor will be able to manage 100 troy ounces with equity worth $3.3K.
Spot price and commercial gold
While spot and futures prices are usually balanced by arbitrage, things are different for commercial gold, which is the only over-the-counter asset. Its value is influenced by the mark-ups charged by the dealers, which include not only their commission, but also the costs of marketing, storing and insuring the products. In the case of coins, the price is also influenced by their rarity. At the same time, the price paid by end customers also depends on the production capacity of the profile market, a value that is variable.
On the other hand, equipment for the production of coins and bullion requires large investments, and not infrequently, until they become fully functional, the price of gold in the respective market can fall. We must also bear in mind that the investment in equipment to produce coins and bullion is high, and by the time a machine is installed and operating, the price of gold may have begun to decline.
In this context, it often happens that there is a lack of commercial gold in a certain market, which leads to an increase in the selling price of physical assets, which ends up being the spot price + a certain percentage. The higher the demand against the supply, the higher this percentage. This allows us to assess the situation of a particular market, not the global gold market.
In short, knowing the different types of gold prices, how they interact, and the factors that influence their changes is essential to profitable gold investing. Moreover, gold price fluctuations can be a good indicator of trends in every market in the world.
