While most people think investing in gold means heading down to your local coin and bullion dealer and buying up as much gold as you can afford; in actuality, there are a growing number of ways that you can invest in gold without owning any physical gold at all.
With sophisticated financial products designed to leverage the staying power of gold, many investors today prefer visiting the brokerage rather than the gold dealer.
How Futures Work
A future is a type of financial derivative. It is an enforceable contract between two parties characterized by an agreement to pay a certain price for a certain good at an agreed-upon point in the future.
When you buy a futures contract you don’t actually buy the good you’re investing in, what you buy is the contract to pay a price for a particular amount on the day the contract comes due. Most futures traders sell their contracts before they actually come due and never actually buy any product at all.
What buyers hope is that the price of the commodity will go up before the due date. If that happens, the trade will have been a profitable one because the buyer of the contract has the right to buy the commodity at a cheaper rate than the prevailing market rate. As a buyer, you can immediately sell the goods at the current market rate and rake in a tidy profit.
The Magic of Margin
So what does all this have to do with gold investment? The biggest allure of trading in gold futures is that you can buy on margin, which means you can invest in a much larger pool of goods than if you had bought gold outright. This is because, if you buy a gold future on a 10 percent margin, you only have to put up 1/10th of the cost of the actual price of the gold being traded.
Let’s look at an investment scenario using arbitrary numbers:
If you had $1,000 to invest and you bought gold bullion, you would only have $1,000 worth of gold bullion. If you invested that same $1,000 in gold futures you would have an investment of, let’s say, $20,000. Subsequently, if the gold market goes up by 10 percent, your $1000 in bullion would now be worth $1,100. But if you had invested in futures, your $20,000 in futures would now be worth $22,000, giving you a profit of $2000. You only invested $1000, but you just made a $2000 profit.
So why doesn’t everyone do this? The answer is: it works both ways. If that same $1000 investment goes down in value by 10 percent, your $1000 in bullion is now worth $900, while the futures investor has lost $2,000, as the contract would be valued at $18,000. Instead of just losing a small fraction of your investment, as a futures investor you are liable for the entirety of the contract. And that’s scary stuff for a lot of investors. Small fluctuations in the market can mean big gains, but equally big losses.
Another caveat is lot size. Whereas you can buy any number of shares when trading in stocks, futures contracts are defined by lot sizes. In the realm of gold futures, lot size is usually defined by troy ounces, where one lot is 100 troy ounces. As an investor, you are typically only able to invest in increments of 100 troy ounces.
All in all, gold futures may promise big rewards, but they also carry with it the very real threat of losing a lot of money. It is certainly not for the faint-hearted.