Metals and Minerals, A. Jonathan Buhalis
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by Jonathan Buhalis

Commodities Markets Defined

Trading in commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.

Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized Contracts.

A Commodities Exchange is an exchange where various commodities and derivatives products are traded. These contracts can include spot prices, forwards, futures, and options on on futures.

Commodities exchanges usually trade futures contracts on commodities. Such as trading contracts to receive something, say corn, in a certain month. A farmer raising corn can sell a future contract on his corn, which will not be harvested for several months, and guarantee the price he will be paid when he delivers; a breakfast cereal producer buys the contract now and guarantees the price will not go up when it is delivered. This protects the farmer from price drops and the buyer from price rises.

Speculators also buy and sell the futures contracts to make a profit and provide liquidity to the system.
"Derivative" - that which is derived.

"To derive" - to draw from a source

Spot and Alternatives The gold price quoted in the international market is the spot price in US dollars per troy ounce. A "spot" price is the price quoted for metal to be delivered, and paid for (in the case of gold), two days after the transaction date.

Other forms of transaction, notably forwards, futures and options, are those that will be either settled and delivered against, or unwound, at a date further in the future than the spot settlement date. These are known as derivatives and were originally developed as a form of price protection. Futures can be (and often are) used as a hedge mechanism by members of the industry and examples as to how this works are provided below. However, when derivatives are used purely by traders who do not have an offsetting position in the physical market, then they are a means of speculation and must be traded with care, especially as they operate using margin, or deposits, rather than lines of credit. If a speculator does not have the capacity to take delivery of a long position, or the metal to deliver against a short, then he must settle financially and volatility in price can mean chasing losses.

Risk Management & the Development of Hedging Derivatives were devised as a means of hedging price risk, i.e. reducing exposure to adverse price movements. Some are also for speculation, notably (but not exclusively) the futures contracts on the COMEX division of NYMEX and on TOCOM. New exchanges have been opened in India since 2003, with a view to both hedging and speculation. These are the Multi Commodity Exchange of India (MCX) and the National Commodity and Derivative Exchange (NCDEX). In the second half of 2005 an important new development sees the opening of the Dubai Gold and Commodity Exchange, with Dubai and Indian authorities working in collaboration, which summarizes the different exchanges around the world and their functions.

History of Futures Trading Futures trading is not the child of the twentieth or even the nineteenth century. In the Roman Empire, commodity markets known as fora vendalia were important as distribution centers for products that came from all over the Empire. Along with the Agora in Athens, the Forum in Rome started life as a market. These markets used both bartering and currencies, and would price for future delivery.

Much later, futures markets developed in Japan in rice (17th century) and then in Chicago in the first part of the nineteenth century when Chicago found itself at the center of grain trading. Because it took time to deliver the produce from farmland to the terminal market, merchants developed a system of forward pricing, matching both buyer and seller and the first recorded forward contract was struck in March 1851.

Formal futures contracts were developed over time as a result of the perceived need for consistency and standardization. The Chicago Board of Trade started developing futures in 1865.

The concept of time from striking a contract to point of delivery is the key to the development of forward and futures markets. The reason that the London Metal Exchange's flagship contract is "three months" is because when the LME (which is a futures market) was founded in 1877, it took three months for copper to be shipped from Chilean ports into London (and similarly, latterly, tin from the Far East).

The first futures market in gold was opened on what was then Commodity Exchange Inc (COMEX) in New York on December 31st, 1974. COMEX has since merged with the New York Mercantile Exchange (NYMEX).

Options in gold were initially developed on the Over the Counter market by Mocatta Metals Corporation (now Scotia Mocatta) and Valeurs White Weld (now CSFB), in the late 1970s. Exchange-traded options were launched on COMEX in 1982.

Forwards and Futures The difference between forwards and futures is as follows:

A futures contract is an agreement to buy or sell a specific amount of a commodity or financial instrument at a particular price on a stipulated future date. The contract can be sold before the settlement date. Typically less than one percent of metals futures contracts on NYMEX ever come to delivery. Futures contracts are standardized in terms of unit size and delivery dates.

A forward contract is an Over the Counter, or principal's contract, which may be of any size or maturity date, subject to the agreement struck between the counter parties. It is clearly, therefore, not standardized in terms of size or delivery date and more flexible than an outright exchange futures and the majority of physical business takes place on the Over the Counter basis.

The forward or future price that is agreed is a function of the underlying spot price, and the prevailing interest rates in the money markets, plus insurance and storage.

Because gold has vast quantities of aboveground stocks, forward prices almost invariably (but not quite always) rise as the maturity of the contract extends. The difference between this premium over the nearby price is known as the contango. When expressed as a percentage, it is usually very close to the money market interest rate; i.e. gold's contango is usually close to "full carry". If for any reason there is a squeeze on material due for delivery on a particular date or range of dates, something that happens not infrequently in the non-ferrous metal markets, then this forward curve can be severely disrupted. If a price for delivery on a date in the future is lower than the price for delivery nearer in time, then that mismatch is known as a backwardation (or "back").

Options & Spot-Deferred are newer and slightly more complicated derivative instruments, again used largely for hedging although speculators also use options. Spot-deferred are geared much more to the "trade", or industrial, side of the market, especially miners.

An option is a contract that gives the buyer of the option the right but not the obligation to buy (call option) or to sell (put option) a quantity of the underlying asset at a specified price (strike price) by or on a certain date. The seller of the option is the "writer" or "grantor". An option writer holds a "naked" position when he has written an option without having the asset behind it.

An option is in-the-money if, in the case of a call option, the strike price is below the prevailing price of the underlying asset, and in the case of a put option if the strike price is above the prevailing price of the underlying asset. If the reverse situations apply then the option is said to be out-of-the-money. An option is at the money if the price of the asset equals the prevailing price.

Varieties of Options There are many types of option available to the market; we propose here to stay with the simplest.

European Options may only be exercised on the date of expiry and are the predominant option in the London bullion market. Each contract, as with forwards, is tailor-made between two counter-parties and may be for far forward dates and in considerable volume.

American Options may be exercised on any day up to and including the expiry date.

COMEX options. These are options on COMEX contracts and are therefore options on futures. As with futures, these are standardized contracts rather than the bespoke transactions in the OTC market, and are freely tradable. These instruments, like the futures contracts themselves, attract a high degree of speculative activity.

A spot deferred contract is a forward contract in which the contracts are rolled forward as they mature. There is thus no pre-specified delivery date, and as each contract comes to maturity it may be rolled forward with fresh interest rates applied. The facility is, however, set up such that it will to terminate within a pre-determined maximum period (e.g. a client may roll forward every three months up to ten years). These long-term contracts have been popular with some of the mining fraternity. Each time the contract comes up for rollover, the terms (interest rates) are adjusted to reflect prevailing conditions in the dollar and gold markets and for this reason the contracts are sometimes described as floating rate forwards. The flexibility they offer means that a hedger may deliver into his contract at one maturity date if the spot price is high, or may roll forward if he so prefers.


The difference between the "bid" and the "offer" is known as the spread. In the gold market this is typically somewhere between 50 cents and one dollar, which at $ 430/ounce gold equates to 0.11%-0.22%, or 11-22 "basis points". A basis point is one-hundredth of one per cent.

A forward price is a function of the spot price of the underlying commodity (or currency) plus a premium based on prevailing interest rates in the currency, in which that commodity is priced, plus storage and insurance charges. It is outlined above how the gold contango usually, though not always, is at close to full carry. The forward premium will be quoted as a percentage of the underlying price.

A dealer making a two-way forward price will calculate a forward price at which he will buy, and similarly for that at which he will sell. If the forward rate is, say, one per cent annualized (bid-rate), then the one-year forward bid-price will be the spot bid-price raised by one per cent. If the forward offered rate is 1.1% then the one-year forward offered price will be the spot offer raised by 1.1%. The forward rate for gold is the prevailing dollar interest rate in the financial markets, less the interest rate that gold will achieve if loaned out over the period of the forward transaction.

The "Buy" Leg

Buying forward effectively works as follows: a dealer sells spot metal, and raises dollars as a result of the transaction. These dollars will be used to buy forward metal. This forward purchase of gold will not actually be settled (i.e. the gold and the dollars will not change hands) until the settlement (forward) date; therefore the dollars raised through the spot sale of gold are put on deposit to earn interest until they are needed for payment. Equally, the dealer will pay a forward premium for the gold that he is buying.

By selling gold spot and buying forward, the dealer is effectively lending gold to the market. The gold that the dealer sells into the spot market will probably, but not necessarily, have itself been borrowed from the official sector; is not is not unknown for investment funds to lend metal to the market if it finds that the circumstances are attractive.

The "Sell" Leg

Equally, if a dealer is to sell forward, he is effectively borrowing gold. He would buy metal from the spot market, then sell it forward. The dollars for buying the spot gold are borrowed from the dollar interest rate market and are due to be repaid on the day that the gold transaction closes. The dealer thus incurs a dollar-borrowing cost. He therefore adds an interest rate to his bid price and a (higher) interest rate to his selling price.

Example of a Forward Price

On March 31st 2004, spot gold was fixed in the afternoon at $427.50/ounce. The interest rate that a dealer might be prepared to pay for one year forward was 0.70%, and to charge, was 0.80%. On a spot market of, (say), $ 427.00-427.50, this would mean a forward price for one-year gold of 430.00-430.90, a contango of $3.00-3.40. This is calculated as $ 427*1.007 (bid) and $ 427.50*1.008 (offer).

For periods different from a year, the interest rate quoted is the annualized rate and this is then adjusted by the number of days between spot and the maturity of the contract. The London market works on the basis of 360 days in the year.

Options Trade and Pricing

The purchaser of an option has the right but not the obligation to exercise that option. The price paid for an option is known as the premium; the strike price is the pre-determined price as which an option may be exercised. While the purchaser of the option is therefore relatively well protected, in that his only risk is the premium that he has already paid (if the market goes badly against him his option will expire worthless), the writer or grantor of the option has risk against him throughout the life of the instrument.

Part of this risk is therefore built into the pricing of the premium at the outset. There are numerous models of varying degrees of sophistication for pricing models, but the essential components that have to be assessed (apart from the prevailing price and the strike price) are: time to expiry; potential costs to the grantor in terms of financing any metal or currency transaction that he has to undertake in order to hedge his exposure; and price volatility. When prices are volatile, option premiums tend to increase as the risk to the grantor is that much greater than when the market is flat.

The delta is the degree of change in an option's premium for a given change in the price of the underlying asset and is undertaken by the grantor of the option. The grantor of a call is, technically, potentially short of the market as he may need to settle with metal if he is called away (i.e. the buyer of the option chooses to exercise). As the time to expiry decreases, or the option goes further into the money, or as volatility increases, the grantor will (in this case) enter the underlying market as a buyer to cover a part of his risk. In the first of these instances the change in price of the option will increase as maturity approaches because there is less time decay attached to the transaction; in the second case the probability increases that the option will be exercised; and in the third case high volatility commands extra protection. The volume of the metal that he carries against the option, as a proportion of the total volume represented by the option, is the delta. The same works in reverse with the seller of a put, who may need to sell metal against his short put position if prices are falling.

Futures and their Adjuncts

Futures contracts, as outlined above, are standardized so that each contract traded on an exchange is of the same size and purity of metal as all the other contracts in that commodity traded on that exchange; also the point of delivery (should delivery be made) is precisely specified, as is the period of time within which delivery must be made. In practice, generally less than 1% of futures contracts come to delivery as the majority of the clients with physical metal choose to deliver through the normal channels but use the futures to hedge their price risk.

Trading through an exchange such as the COMEX division of NYMEX is effected though futures brokers who act as independent agents. The source of the deal may therefore remain anonymous. COMEX trading is centrally cleared, which technically eliminates counter-party risk as the client is trading with the Exchange, which has matched him with an equal and opposite trade from an other counter-party.

ACCESS is the COMEX after-hours electronic trading mechanism. Currently there are terminals in major cities in the US, along with London, Ireland, Sydney, Hong Kong, Singapore, Japan, Bermuda, US territories and possessions, and UK territories and possessions. Trading commences at 4pm NY time (7pm on a Sunday) and continues at 8 am, giving an effective trading day (including COMEX open outcry) of 22 hours.

EFP (Exchange for Physical) is the exchange of a futures contract for a position in the cash market. This may be carried out during or outside exchange trading hours. The "EFP" is also the price quotation specifying the price differential between the spot price and the price prevailing for the relevant futures contract. One advantage of this is that the client, by executing an EFP to a physical position with a named dealer, can then (at the appropriate fee) take delivery of metal where and when he wishes, as opposed to the time and place previously specified through the Exchange.

A client trading on the futures exchanges is required to deposit an initial margin with the Exchange when he opens a position. This money is emplaced in order to guarantee that a client will be able to fulfill his obligations. After depositing his Initial Margin, he must then maintain a minimum "maintenance" margin on deposit at all times and, if a client's position goes against him and he effectively has less in his trading position than his maintenance margin requirement, he will be called upon to put up additional margin to cover the losses (on paper) that are being incurred. This is referred to as a margin call and effectively insures the Exchange against default. This is one reason why speculators must trade with care, as an adverse position can prove expensive.

Using Futures to Hedge Price Risk

The purpose of hedging price risk is to minimize the impact of adverse price movements. Effectively, locking in a future price for the date of delivery of the metal means that the producer, consumer, merchant, etc. knows the price that he will command or receive on the day in question. Hedging can be as simple as taking out a contract that exactly offsets the tonnage involved in the physical market for a single date of execution (known as a "blind hedge") or it can allow the flexibility to alter positions as market conditions change (a "selective hedge"). Further, it can extend to multiple uses of contracts, options and more complicated structures spread over a series of maturity dates.

Hedging: Simple Principles

The important principal to bear in mind here is that a forward or futures prices is a function of interest rates, storage and insurance charges for a given period of time. Consequently, all other things being equal, a forward price will be higher than a nearby price and as the time value of the contract dwindles to zero, so does the difference in price. In other words, once the futures contract has become spot, so by definition its designated price is the spot price.

Using Futures This means that when a trade client holds gold and takes out a contract to sell it in (say, December) at a price of $440/ounce, he knows that that is the price he will receive. The reasoning is as follows. He has sold the contract at the outset for $440/ounce. He unwinds the contract at maturity by buying the contract back at the spot price. At the same time, he sells the metal into the physical metal into the physical market for the spot price. Difference between the two, zero; amount received; $440/ounce.

If on maturity, the spot price were $420/ounce, the client would have locked in a profit of $20/ounce over spot. If however the price were $460/ounce he would have incurred an opportunity cost of $20/ounce. In practice, futures rarely, on NYMEX, come to delivery and if prices had been moving against the client then he would almost certainly have adjusted his position before maturity. The same applies in reverse for a long-side trader.

A "trade" client, e.g., a mine producer or a jeweler financing his inventory in this way, uses the exchange to lock in a price so that he can plan, and at least lock in a minimum profit on his products. If the market starts to move against him then he can either adjust his position or run it to maturity and deliver accordingly.

A speculator is in rather a different position. He does not have the metal to deliver against a loss-making short position, and will not wish to take delivery of metal against a long position and this is why speculators will often run their positions with close "stops", in order to minimize risk. He will also face margin calls on loss making positions. This is why it is important to realize that the futures markets are a good mechanism for hedging physical positions, but speculative losses, as well as gains, can be substantial.

A Stop-Loss Order is a resting order left with the broker and is designed to close the client out of a loss-making position. Generally the price has to trade on the other side of the stop-loss price for the order to be triggered. So, therefore, if a client is running as long position in December gold with a "stop" at $445/ounce, then once the December price trades below $445/ounce his order will be triggered and he will be sold out of that position as soon as is feasible. In a fast-running market, this is not always at a price close to the order!

In a thin market, powerful players may try to push a price through levels where it is believed that a number of stops may have built up, because this will accelerate the move in the market and potentially (but by no means always successfully) generate profits for those elements who have successfully caused stops to be elected. This is called gunning or probing for stops. This ploy does not always work; sometimes players will probe for stops, not find them, and have to lock in losses themselves.

A limit order, by contrast, is an order that lies on the profitable side of a trade. It rests with the order in the same way as a stop-loss order. So if our client has a long December gold position at $440/ounce and wishes to lock in a profit at $460 December, then he places a limit order accordingly. Once $460 December is touched (rather than breached), the order is triggered and he will be closed out on the next possible trade.

The basic theory of trading for the future is the same whether the client is using futures or forwards - i.e. the forward date becomes the spot date on maturity. Clients using forward contracts will not necessarily be trading on initial margin, but on a principals' contract, using lines of credit. There have, however, certainly been instances of principals' contracts when clients have been called for margin when their finances sheet has been deemed insufficiently robust to handle a position that has gone badly against them.

Forwards are tailor made rather than standardized, and this is one of the reasons why the Exchange-for Physical exists; as a contract is coming to maturity so a client may refine the specifics of his contract using an EFP and then finessing with his counterpart.

Both forward and futures have vital roles, therefore, and each market participant will, if possible, use on or other or both to his best advantage.

Selected Gold Market Facts

  • New York is the home of the largest gold futures trading through Comex (its commodities exchange).
  • Tokyo, through Tokyo Commodities Exchange (Tocom) , is the second largest futures trading center in the world for gold.
  • India's Multi Commodities Exchange (MCX) is the world's third-biggest gold exchange. It accounted for just under half of the $476 billion worth of the 91 commodities traded on 24 Indian futures markets in the year ended March 31. The value of trades in the six months to October outstripped the previous year, more than doubling to $487 billion.
  • London Bullion Market is the largest spot market for gold.
  • The London Fixing Price is the basis for transaction prices in gold and is Followed as the universal spot price.
  • After London- the second principal spot or physical gold trading is Zurich.

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