Gold, the shiny yellow metal, has a special place in the hearts and portfolios of Indian investors. But retail investors have limited their exposure to just physical gold. How many of us invest or have even thought of investing in gold futures? Very few.
The very concept of gold futures trading seems daunting to us. We have been told that futures trading is extremely risky. Additionally, gold’s value is dependent on external factors. So, gold and futures trading is a bad combination.
But this is not true. Gold futures is arguably one of the most lucrative opportunities in the Indian derivatives market. Think about it…
- The demand for gold will never go down. It is a prerequisite in our weddings or any auspicious occasion.
- Central Banks across the globe own trillions in gold bullions.
- Gold is a store of value during geopolitical tensions or economic downturns.
With such big positives, ignoring gold futures trading would be a critical mistake for traders or investors. But before you jump the gun, you first need to understand the basics of gold futures trading. This is exactly what we will cover in today’s discussion.
In this article:
- What is Gold Futures?
- Advantages of Gold Futures.
- Factors Affecting Gold Futures
- How Does Gold Futures Work?
What is Gold Futures?
Futures is a contract between two parties to exchange the underlying asset in the future at a pre-decided date and price. The underlying asset can be –
- Equities (stocks), Bonds etc.
- Currencies (Indian Rupee, US Dollar, Great Britain Pound etc.)
- Commodities (gold, silver, iron etc.)
- Weather (yes, there are futures contracts on weather as well) etc.
A gold futures is a contract between two parties to exchange gold at a pre-decided rate and date in the future. This is possible when both parties have opposite views on gold… One is expecting gold prices to go up, while the other is expecting it to fall.
Watch this video to learn about commodities
Let us understand gold futures trading with a simple example –
Gold Futures Contract Example
Mr Verma’s daughter is set to marry after six months. He wants to gift her 50 tola or 500 grams of gold. The price of gold on 1st September 2021 is Rs 47,090 per 10 grams. Mr Verma expects that the price of gold will increase as the third wave of the pandemic spreads. So, investors will shift from risky assets like equities to a safe haven, which is gold. This will increase gold’s demand and price.
Worried, he approaches his trusted Jeweller, MahaKalyan Jewellers. The jeweller disagrees with Mr Verma. He believes that the market has already accounted for the third wave. So investors will stay invested in equities and the demand for gold will fall. This will also lead to a fall in gold prices.
This is when both of them decide to enter into a gold futures contract. It is mutually decided that Mr Verma will buy 500 grams of gold from MahaKalyan Jewellers on 1st March 2022 at Rs 47,500 per 10 grams.
In the above agreement –
- Mr Verma is the buyer of the futures contract. He is said to be ‘long on gold’.
- MahaKalyan Jewellers is the seller of the futures contract. They are said to be ‘short on gold’.
- Rs 47,090 is the spot price of gold.
- Rs 47,500 is the strike price of gold futures contract. This is the price at which gold will be exchanged on expiry.
- 1st March is the expiration date for the contract.
- 500 grams of gold is the lot size.
An important thing to note in a futures contract is that both the parties are bound by the contract. Irrespective of gold prices at the time of expiry, Mr Verma has to compulsorily buy the gold, he cannot say no.
Similarly, Mahakalyan Jewellers have to sell the gold to Mr Verma. They cannot refuse. This is unlike an options contract, where the buyer has the right to not exercise the option.
Another thing is that all futures contracts are traded on stock exchanges. So, Mr Verma and MahaKalyan Jewellers are just two parties behind the trading terminal with opposite views on a stock or commodity. Gold futures are traded on Multi Commodity Exchange of India (MCX).
Only three things can happen after six months –
- Gold price increases – the new price is Rs 49,500 per 10 grams.
- Gold price remains flat – the price is unchanged at Rs 47,500 per 10 grams.
- Gold price decreases – the new price is Rs 45,500 per 10 grams.
Scenario 1: From Mr Verma’s Point of View – Gold price increases to Rs 49,500 per 10 grams.
Mr Verma’s prediction has come true. Now, he will buy 500 grams of gold from MahaKalyan Jewellers at Rs 47,500 instead of buying it from the market at Rs 49,500. So, he has made a profit of Rs 2,000 (Rs 49,500 – Rs 47,500) per 10 gram. His total profit is Rs 1 lakh.
Scenario 1: From MahaKalyan Jeweller’s Point of View – Gold price increases to Rs 49,500 per 10 grams.
MahaKalyan jewellers are forced to sell 500 grams of gold to Mr Verma at Rs 2,000 less than the market rate. So, even though they can sell 500 grams at Rs 49,500, because they have entered into a futures contract with Mr Verma, they have to honour the contract. They suffer a loss of Rs 1,00,000.
Scenario 2: Gold price remains flat – Rs 47,500.
This is a no-profit, no-loss situation for both Mr Verma and MahaKalyan Jewellers. Since the market price is equal to the strike price, both of them honor the futures contract.
Scenario 3: Gold price decreases to Rs 45,500 – Mr Verma’s Point of View
Now, Mr Verma is at a loss. He can buy 500 grams of gold from the market at Rs 45,500 but he cannot do so. He is obligated to buy it at Rs 2,000 extra i.e. Rs 47,500. His total loss is Rs 1 lakh.
Scenario 3: Gold price decreases to Rs 45,500 – MahaKalyan Jewellers Point of View
This is exactly what MahaKalyan jewellers expected. Now, they can sell 500 grams of gold to Mr Verma at Rs 47,500 instead of selling it in the market at Rs 45,500. They have made a profit of Rs 2,000 per 10 grams or Rs 1 Lakh in total.
|Party / Position||Expectations||Profit|
|Buyer / Long Position||Price will increase||Spot Price > Strike Price|
|Seller / Put Position||Price will decrease||Strike Price > Spot Price|
Notice that Mr Verma’s profit is the same as MahaKalyan Jewellers loss. In the first scenario, Mr Verma made a profit of Rs 1 lakh, while MahaKalyan Jewellers lost Rs 1 lakh. Hence, futures trading is also known as a zero-sum-game.
In our example, Mr Verma and MahaKalyan jewellers knew each other and met physically to exchange gold. But a futures contract is not personalised. It is standard in nature and is traded on an exchange known as the Multi Commodity Exchange.
[Read More: Basics of Futures Contract in India]
Let us now look at a real gold futures contract on Multi Commodity Exchange (MCX).
There are four types of MCX gold futures contracts –
- MCX gold futures – 1 Kg gold.
- Mini MCX gold futures – 100 grams of gold.
- Guinea MCX gold futures – 8 grams of gold.
- Petal MCX gold futures – 1 gram of gold.
Did you know that MCX is the world’s first commodity exchange to launch 1 gram of gold futures contract! So, basically MCX is offering investors the opportunity to invest as per their risk appetite. But, of the above, 1 Kg gold lot size is the most popular and liquid in India.
Let us now look at the contract specifications of MCX gold futures.
|Contract Start Date||16th of every month|
|Last Trading Date||5th of contract expiry month|
|Trading Unit||1 Kg|
|Maximum Order Size||10 Kg|
|Initial Margin||6% of contract value|
The basic rule of derivatives is – Movement of a futures contract will always be in sync with the underlying asset. So, if gold goes up, gold futures will also go up. Gold futures are dependent on the underlying gold prices. This is why it is important to understand what affects gold prices before trading gold futures.
Factors Affecting Gold Prices & Gold Futures
Demand and Supply: China, South Africa, Australia are some of the biggest producers of gold in the world. While India is one of the largest importers of gold. In India, gold is in heavy demand during wedding season or auspicious occasions like Diwali and Akshay Tritiya. Even monsoon or a good harvesting season affects gold prices as a big chunk of gold’s demand comes from rural India. A good monsoon means good harvest, sales and higher disposable income. Due to unlimited demand but limited supply, there are high fluctuations in the price of the yellow metal.
Gold & US Dollar: Since gold is imported in India, payments are made in US dollars. A weak dollar means you can buy more gold with less dollars. So, the demand for gold automatically goes up when the dollar becomes weak. Central banks consider this a great buying opportunity. Also, when the currency of the biggest economy of the world falls, there is a pessimistic atmosphere in the markets. At this point, investors move from risky assets to gold, which increases its price.
Mining & Distribution Costs: Gold is mined in far-off countries and then exported to India. So, it has mining, refining, transport and distribution costs attached with it. Any increase in these factors will cause an automatic rise in the price of gold and gold futures. Since gold has been mined for centuries now, mining and distributing companies have mined-off easy gold. Now they need to mine deeper to find quality gold. This means mining companies have to invest more money and manpower to find quality gold. High costs also drive up the prices of gold and gold futures.
Central Banks: They are some of the biggest consumers of gold in the world. Central banks of most countries maintain huge gold reserves as a store of value and to maintain the value of the domestic currency. The Reserve Bank of India has to maintain a minimum reserve of Rs 200 crores in gold bullion before printing fresh currency.
So, when central banks are on a buying spree, it automatically causes an increase in the price of gold and gold futures.
Interest Rates: Gold prices and interest rates have an inverse relationship. When interest rates in the market are low, investors prefer investing in gold where they find a store of value and inflation-adjusted returns are positive. Whereas when interest rates are high, investors will shift from gold to fixed income instruments for higher inflation-adjusted returns.
Geopolitical Tensions: During geopolitical tensions or wars, gold becomes the preferred choice for investors since it is a store of value. So, while currency depreciates, gold will retain its value and hence the demand and price of gold goes up during geopolitical tensions or trade wars.
Advantages of Gold Futures
- No Storage Cost: When you buy physical gold, you either store in your home or a bank locker. When you store it at home, there is an ever-present danger of theft or loss. When you store physical gold in bank lockers, you have to pay an annual locker charge. And mind you, even bank lockers are not 100% insured. This hassle, cost and fear is eliminated when you invest in gold futures. These electronic contracts are bought and sold through demat accounts and are highly secured.
- Less Capital Required: If you want to buy 1 kg of gold today, you will have to shell out Rs 47.09 Lakhs (Rs 47,090/10*100 grams). But you can take the same position in gold futures for a fraction of the cost. This is because gold futures are highly leveraged. We know that 1 gold futures contract has 1 kg of the underlying asset. The current price of gold futures maturing on 5th October 2021 is Rs 47,119. So, the total value of your contract is Rs 47.11 Lakhs. But you do not have to pay the entire amount upfront. You only have to deposit a margin amount to enter into this contract. Let’s assume that the margin required for gold futures is 4%. In this case, you can take exposure to 1 Kg gold futures contract with a margin amount of Rs 2.82 Lakhs only.
- Intraday Profit Booking Allowed: When you buy stocks for delivery, they are credited in your Demat account after two days (T+2 day settlement). So, even if there is an intraday opportunity available, you cannot sell the stocks before T+2 days. But in the case of gold futures, you can trade intraday as well.Take the below example – On 2nd September 2021 –
- 9.00 am – I buy a gold futures contract on Gold (1 Kg of underlying gold) for Rs 47,216 per 10 grams.
- Total Value of my position = 4721.6*1000 = Rs 47,21,600
- Margin Required = 6% of contract value = Rs 2,83,296
- During the day, it hit a high price of Rs 47,369. I sell my one lot at this price.
- Total sale price = Rs 4736.9*1000 = Rs 47,36,900
- Total Profit is Rs 15,300 on an investment of Rs 2,83,296. This is a gain of 5.40% in one day
4. High Liquidity: Liquidity is the ability to convert an asset into cash without any loss in value. Physical gold is comparatively less liquid than gold futures. In the case of physical gold, you have to visit a jeweller, who will deduct making and other charges from the overall weight. So, while liquid, physical gold loses value when converted into cash. On the other hand, gold futures enjoy high liquidity and can be sold within minutes. Also investors can be assured of the gold’s purity as gold futures are based on 995 purity gold.
5. Option to Short Sell: Short selling as a concept is available in the case of stocks and derivatives only. Short selling is not possible in the case of physical gold. That is, you cannot sell physical gold that you do not have! But this is possible in the case of gold futures.The below screenshot shows the intraday movement in GoldPetal.
- On 1st September 2021, at 10.01 am. GoldPetal futures were trading at Rs 4,719. Suppose, I sold (short sell) one lot of GoldPetal futures.
- At 13.39 pm, it fell to Rs 4,707. I covered my short sell and bought one lot at Rs 4,707.
- The difference, Rs 13 (4,719-4,707) is my profit. This kind of short selling opportunity is possible only in the case of gold futures, not physical gold.
A very important topic to discuss while understanding gold futures trading is leverage. It is a controversial topic as it is a double-edged sword for investors. Consider the following gold futures transaction.
I go long on Gold futures contract on 2nd August 2021 at a price of Rs 48,086 per 10 grams. 1 Gold futures contract is for 1 Kg underlying gold.
- Total Contract Value = Lot Size * Price
= Rs 48,086 * 100 = Rs 48,08,600
- Initial Margin Required = 6% of Contract Value
= Rs 2,88,516
So, I’m able to take a position worth Rs 48 Lakhs with just Rs 2.88 Lakhs.
- Leverage = Contract Value / Margin Required
= Rs 48,08,600 / Rs 2,88,516 = 16 times.
So far so good. But why did I refer to leverage as a double-edged sword? Simply because even a 6.25% fall in gold prices can wipe off your entire Rs 2,88,516!
Formula to Calculate 100% Margin Loss = 1/Leverage
Now imagine if the margin was only Rs 1 lakh. Now your leverage is 48 times. This means that a fall of 2.08% in gold will wipe off your entire margin! This is why leverage is a double-edged sword and should be used judiciously.
Settlement of Gold Futures
A Gold futures contract can be settled in two ways –
- Cash Settlement
- Delivery Settlement
Let us go back to the Mr Verma and MahaKalyan Jewellers example. Suppose on the expiry, 1st March 2022, gold prices go up. Mr Verma will demand his 500 grams of gold and MahaKalyan Jewellers will have to deliver it.
Now MahaKalyan Jewellers can either deliver actual physical gold or settle this transaction in cash. For cash settlement, MahaKalyan Jewellers will pay Mr Verma the difference between the strike price and the spot price. That is, Rs 2,000 per 10 grams or Rs 1 Lakh in total.
Gold futures are settled on the 5th of every month. If you don’t want to take or give delivery, then you must square-off before 1st of the month.
As we mentioned earlier, gold will always be in demand. This makes gold futures highly lucrative. But you must ensure that you do not misuse leverage. And remember, futures is a zero-sum-gain. To trade in gold futures on MCX, open a FREE Demat and trading account with Samco – India’s most trusted broker.
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