Trading in Gold Futures

Gold has attracted people due to its shine and density. The precious metal can also be easily shaped into intricate designs. Over time gold evolved from being a collectable commodity to a symbol of status, wealth and power.

Indians, too, have had a love affair of gold for thousands of years. So valued is the precious metal that it is considered auspicious to purchase gold on festivals, worn as jewellery at religious and social occasions and even sometimes eaten. For these and more reasons, the gold futures market is on the rise.

Demand for gold

It’s estimated that Indians bought a mind-boggling 750-850 tonnes of gold in 2019. This makes it one of the biggest markets for this precious metal in the world. A large chunk of sales comes from weddings — 50 percent of annual gold demand is for weddings!

Gold is also sought after by Indians and elsewhere around the world as an investment. Many people consider gold to be a safe asset that earns good returns. Of course, in India, equity has outperformed gold in the past few years.

Fund managers like to have some gold in their portfolio to act as a hedge against an economic downturn. This is because gold prices tend to move in the opposite direction to those of assets like equity. In times of economic prosperity, companies do well, and their share prices go up and beat gold in terms of returns. However, during a downturn, gold does better as people tend to invest more in the precious metal than in companies. Gold is considered as a defensive investment – bought by those who feel that an economic downturn is imminent. Moreover, gold has a good track record of beating inflation as well.

Central banks the world over – the Reserve Bank in India — prefer to keep some amount of gold in their treasuries since the precious metal is considered more stable than currencies. The gold acts as some insurance against unpredictable economic events.

Gold is also used (to some extent) in manufacturing because of its various qualities like malleability, ductility, high melting point, and stability. It is used in sectors like space, medicine, technology and dentistry. However, the fact remains that an overwhelming 75 per cent of newly mined gold is used in jewellery. 

Production and prices

For a long time, South Africa was the biggest gold producer in the world. The scenario has changed in the past few years, and in 2017, the most significant primary gold producer was China with 440 metric tonnes, followed by Australia (300 mt), Russia (255 mt) and the USA (245 mt).

The reason why gold is so expensive is because of the low production. In 2018, only about 3,300 tonnes was produced the world over. Compare that to steel — around 149 million tonnes of the metal was produced at the same time!

As we have mentioned above, gold prices tend to increase during an economic downturn. Interest rates too affect prices – when interest rates rise, investors will prefer to put their money in fixed income instruments rather than in gold. Another is seasonality. Gold prices in India move up at certain times of the year, like the festival of Diwali and the wedding season. During wars and times of civil unrest, people may prefer to hold gold as it is easily portable and has widespread acceptability.

There is also a correlation between the value of the US dollar and gold. A weak dollar will lead to higher gold prices. This is because the weakness of the dollar indicates a weak economy, and people would instead invest in gold rather than an investment option whose performance is linked to the economy.

Gold futures:

There’s another way of investing in gold without actually holding the metal, and that is to buy futures. According to global markets company CME Group, “Gold futures are hedging tools for commercial producers and users of gold. They also provide global gold price discovery and opportunities for portfolio diversification.”

These futures are traded on international exchanges like the New York Mercantile Exchange (Nymex) and the Tokyo Commodity Exchange. In India, you can trade these futures on Multi Commodity Exchange (MCX).

Since gold prices move in a direction opposite to those of many other assets like equity, it’s an excellent source of hedging. Of course, holding and trading gold in physical form is not very convenient because of security concerns and assessing the purity of the metal. You can, of course, hold these futures till maturity and take delivery of the metal. But if you sell them before expiry, you can trade without having ever to take possession. Settlement of these futures contracts takes place on the 5th of every month. If you don’t want to take physical delivery of the metal, you should square off your position before the 1st of the month. Delivery is in numbered gold bars of 995 purity.

For those who want to profit from price movements in the precious metal, these futures are an excellent option. Gold futures contracts are available in several sizes, so you can find one that suits your budget. For example, there is you can get a gold contact for 1 kg if you are a significant player. There are also several smaller sizes like Mini (100 gm), Guinea (8 gm) and petal (1gm). The most popular is the biggest 1 kg gold contract and is the most liquid of them.

Like most other commodities, the margins for gold futures in India are quite low, at around 4 percent. So traders can take significant positions in these futures. For example, you will be able to take a position of Rs 1 crore in gold futures by paying a margin of only Rs 4 lakh. The extensive exposure will mean more opportunities for profit. But the risks are high as well. Gold is an internationally traded commodity, and events in any part of the world will affect gold prices in India as well. Any mistake in your assumptions could lead to significant losses.

Trading in the gold futures market needs a massive appetite for risk, nerves of steel and a thorough understanding of the precious metal and its place in the world economy.

Gold options were introduced recently on the MCX. These are considered safer than futures because you have the choice of not exercising your right to buy/ sell the contract at the strike price. For those who don’t have the stomach for risk, this could be a better `option’.