the mechanics which deny investors a fair profit
by Paul Tustain
April 8, 2004
Apart from the obvious risk of prices going the wrong way there are several little noticed problems with trading gold futures. They combine to make the futures market a difficult place for the investor in gold.
Here are some of the issues concerning the hidden costs of futures trading at the rollover.
Each quarter a futures investor receives the inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced commission rate. To those who do not know how to calculate the correct differential for the two contracts the price is a bit of a magic number, taken on trust. The first thing is to understand where it comes from and how it can be manipulated.
The financing cost
Fair value for the financing cost can be checked by referring to gold lease rates and interest rates. Suppose that gold can be borrowed for 0.003% per day (1.095% per annum) and cash for 0.01% per day (3.65% per annum). The fair value for the next quarter's future should be 90 days times the interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63% over the current one.
However it is likely to be less easy than this because lease rates in particular are very sensitive to time, meaning today's lease rate can be very different to next week's. Most sensible traders would allow for this. They would give themselves a little extra margin for safety. And because the calculation is a difficult one it makes it hard for the investor to evaluate exactly how competitive is the quoted price.
The next issue comes from a predictable fact about the distribution of gold futures positions.
Gold futures shorts are mostly held by market big hitters. They might well be miners, who traded futures intending to settle, or they might be experienced market operators, but whatever they are they tend to be big. The longs are likely to be smaller scale - maybe jewellers, their suppliers and private speculators (all much more likely as buyers than sellers). So while the gross open interest of longs and shorts is in perfect balance, the average size of position is smaller for the longs and there are correspondingly more of them. This provides the trader with an opportunity to gain at the expense of the investor through reducing liquidity.
Suppose the old future is fairly priced at 100. The normal spread is - we'll say - 0.20%. So a typical rollover - selling the old and buying the new - would trade from 99.9 (selling the old future at 100 less half the spread) to 100.73 (buying the new future with the 0.63% of financing cost + half the spread).
But forget the financing element for a moment. The flat price should be 99.9 - 100.1.
Anticipating the distribution the skilful trader can improve his profitability because the nearer the end of the period the more the odds are stacked that whoever is on the phone to trade will be selling a small quantity to close the old future.
Of course these should be balanced by the occasional large purchase, but as we will see that can be got round.
So, if the trader were a saint his price would be 99.9 - 100.1. But he is not, he is a professional trader. So he lowers both his price, and his liquidity.
The quoted price becomes 99.825 - 100.025 sized in one lot, not ten. It seems to the casual eye that there is still a 0.2% trading spread, but is there? Look at the following table - constructed on the basis that there are ten small sellers and one large buyer. Because the trader has reduced his liquidity the buyer has to execute three trades (at different prices) to buy what he wants to close his position.
-1 old (bigger customer wants to do 10)
-4 old (adjusted price on larger purchase order)
-5 old (adjusted price again to complete larger purchase order)
Do the arithmetic and you'll see the trader has engineered to buy from sellers 10 lots at an average price of 99.825 and to sell to buyers 10 lots at an average price of 100.205. For the whole time the price spread quoted was 0.2, but it's actually turned out to be 0.38%. The trader's profit has increased by 90% because of his successful anticipation of the distribution of orders, and the private customers were collectively the biggest contributors.
Running to settlement
Meanwhile the professionals are busy fixing to finance settlement - a luxury not available to the private investor. A big futures player can probably arrange a short term cash borrowing facility for 3%, whereas a private investor might pay 12%-15% which prices settlement out of reach. The known imbalance allows a few large shorts to elect for settlement (i.e. not buying back to close) which cannot easily be duplicated by the smaller longs. A shortage of buyers in the old futures contract develops at the death and it presses the price for small bulls lower.
How low? Clearly there is a floor - because bigger participants will come in to snap up cheap futures to arbitrage against the spot. But the price must fall low enough to enable them to profit from the arbitrage. It turns out the lowness of the price relates to the hassle cost of small deals. They have to be executed, matched, cleared, margined, reconciled and all of this takes people, systems, time and money. Because the professionals all have electronic processing facilities connected to each other the error rates on small private investor trades are the largest, and many even require customer side paper as well as salesman and clerical time on the telephone, to say nothing of a raft of regulatory obligations which don't exist for trades between market professionals.
As a result the trade processing costs of small trades are actually bigger than professional trades of many times their value, so the profitability on transacting them is tiny. Support doesn't appear until there is enough margin in the arbitrage to pay for the costs of many small and expensive-to-process trades, and this allows the dying future to fall below the level at which arbitrage support ought to be predictable.
All this is understood by professionals - and it is self-justifying. Other professionals move short at the death which amplifies the effects.
So succeeding in the gold futures market is far from easy. To be successful you need strong nerves and sound judgment. Private investors should recognize that futures are at their best for market professionals and short term speculations. They are a questionable home for private reserves - especially for those which will be held long enough to roll over repeatedly.
articles in the series include:
Keeping it safe. Securing gold from loss and confiscation
2004 Paul Tustain