A futures contract for trading gold or silver is a legally binding agreement between two parties that involves the purchase, for one party, and selling, for the other, of either of the precious metals at a specified date. These contracts are highly detailed agreements that omit no aspect in trading the specified goods. From quantity to date, quality of the product that is traded and in what conditions, these futures contracts are standardized in order to make the process easier. The only variation that occurs from the purchase of the contract until it is liquidated (or sold) is the price of the commodity on the market. The main advantage that people benefit from when trading in gold and silver futures contracts is the outstanding leverage that allows them to enter a contract sometimes with a lot less than 5% of the contract’s value.
Why trading futures contracts is profitable
Unlike the currency exchange market or the stock market, trading futures contracts is significantly different. Depending on what your interests are, futures contracts can minimize your risk of financial loss or increase it. Of course, in the latter case this risk is assumed by the investor with the possibility of gaining immense profit. The currency exchange market, the flow of commodities and futures contracts are highly interdependent, the difference being that when you acquire a future contract, you are able to do so with very little money. Everything that is required of you when you acquire a contract is an initial margin, which can be as low as 1%. This deposit can be $2,000 for a contract that is worth $50,000 or $325,000, depending on the minimum price movement. If you purchase a contract that is worth $350,000 with an initial margin of $2,000, you stand to gain as much as 50% profit from one minimum price movement. In order to understand how futures contracts are profitable for every day traders who may not be interested in actually purchasing or selling a type of goods, one must grasp the fundamentals of such a contract.
The fundamentals of futures contracts
The futures contracts exchange market has two types of traders: hedgers and speculators. Commonly, hedgers are actual owners of businesses that seek to secure their organization’s profit. They do so by entering a contract which evaluates the main good of their business (which can be wheat, iron ore, meat from livestock, gold, etc.) at a price they are comfortable with, usually the same or bigger than the current price. The contract then states that at a future date, say, next Januay, they will deliver their goods at the specified price. In order to understand how hedging works, let’s take an example. If a wine trader wants to make sure that his business grows, he hedges money into futures contracts. Currently, he sells wine for $10 a litre, which he likes. In order to keep it this way, he enters a contract (sell or short position) which stipulates that he is willing sell 20,000 litres of wine next year at this amount, without knowing what can happen to the price in the mean time. Basically, he invests more money. Speculators may purchase (buy or long position) these contracts if they feel it will be to their advantage.
Next year, the price of wine might be $11, which means that the hedger lost $20,000 ($1 x 20,000), but his business grew exponentially, since his wine now sells for $11 a litre. Every 20,000 litres, he will make $220,000. At the end of the day, he did not lose any money, as his expenses for purchasing the future contract can be deducted out of his profits, yielding a price of $10 per litre, his initial aim.
You don’t need to produce or purchase goods
The great thing about futures contracts is that you don’t have to be a producer or buyer to trade them. In this case, you are an investor looking to speculate on the price of a current commodity by leveraging the margin of these contracts. Another key difference between futures contracts and the stock market are the profits and lossess. Instead of pending for when you sell your contract, your lossess or gains will be added or deducted from your account daily. If, for instance, the price of wine moved up today at $11 and you entered a long position agreeing to buy 20,000 litres at $10, your account is $20,000 richer ($1 x 20,000).
On the other hand, if the price goes down, you will be asked to provide that amount of money, which will be taken from your account. If you don’t, you risk getting your account suspended or even closed. The risks are not infinite, since there is a minimum price movement (tick), as well as limits. If the price of a certain commodity reaches one of its daily limits, then the market for that commodity closes and all contracts have to be liquidated. Sometimes, the high volatility of a price mandates for the limits not to be enforced, especially in the day when a contract is due to expire.
Effectively trading gold and silver futures contracts
With only $2,000 you may purchase a contract for buy position (long) for 1,000 ounces of gold at $350 per ounce for mid February next year. This contract’s entire worth is $350,000 ($350 x 1,000) and it means that in February you are willing to buy the specified amount of gold at that price. It may happen that in December, when gold and silver trades are at their peak, the price of an ounce of gold gradually jumps to $353 and then to $356. At this point, your account has already gained $6,000 (the difference of $6 between your contract’s amount and the current price of gold x the amount, 1,000). Therefore, nothing stops you from selling that contract while you are still ahead. The majority of futures are traded in this manner, also reffered to as offset prior to their delivery date.
Because there is a centralized exchange that regulates the flow of goods and makes investors abide by their contractual agreements, trading futures contracts yields less risk, more integrity, leverage and flexibility for your investments than actually trading these commodities. This makes futures contracts the perfect way to build your way into a sound trading career.