-- Posted Tuesday, 21 January 2003 | Digg This Article

Guest Editorial:   Steve Kopp

There has been quite a bit of bashing of the futures market as of late and I will attempt to present a more objective article on the subject. Let me say in advance that I am bullish on both gold and silver, as are most of the authors on this site. I do have positions in both futures and options on futures. I am bullish for a host of different reasons that I won't discuss in this article.

The futures market provides a liquid marketplace for producers and users of a given commodity to hedge. That is the primary function of the futures market. I will get into more detail about this later in this article. Futures are regulated by the Commodity Futures Trading Commission (CFTC) and backed by the members, banks and brokerage firms that make up the individual exchanges. All contracts have a standard size that does not change for the duration of that contract. For example, a gold futures contract is always 100 troy ounces. A silver contract is always 5000 troy ounces.

Margin is a subject that most people do not understand when they are referring to the futures market. Margin on futures is not the same as margin on stocks. When someone buys a stock and puts up say 50% of the purchase price, he must borrow the rest of the money to pay for his purchase. He now owns that stock at that price. In the futures market, the delivery of the commodity is not until a future date arrives. For example, let's say that Joe buys a gold futures contract (100 ounces) at $350 an ounce that is deliverable in April and it is currently January. Joe does not own gold even though he just bought a futures contract. That futures contract is for gold delivered in April. He will get his gold in April at his purchase price, unless he sells another April contract to offset the contract that he has already bought. Of course, the exchange has to make sure that Joe will honor his obligation to buy that gold at that price. The exchange therefore makes Joe put up some money (currently $1,350) in his brokerage account. The exchange makes the seller of the contract put up the same amount. Remember that Joe has not actually purchased any gold yet. He has locked in a price, but is not obligated to buy the gold until April. The $1,350 is just a good faith deposit. If the market moves against Joe the exchange will require him to put up additional good faith money. If April gold falls to say $346 per ounce Joe will be losing $400 ($4 x 100 ounces) on his contract. The exchange will then demand that Joe put up an additional $400 to bring his good faith deposit up to the exchange margin requirement. The seller of the contract will be credited with the $400 as he is making profit by that amount. Price moves up or down are credited or debited to the account daily or even intra-day. Even though Joe controls $35,000 worth of gold, he does not yet own it. Why should Joe have to put up $35,000 (as some people have suggested) if he is not actually purchasing the gold until April?  The exchanges can and DO change margin requirements as market conditions warrant. Volatility and price are the main factors in determining margin requirements. If the market becomes volatile, margin requirements are sure to be raised. The exchange raises margin requirements to protect itself (it guarantees all transactions) against buyers or sellers who may have a change of heart if the market suddenly moves against them. If the market becomes extremely chaotic, the exchanges may limit transactions to offsetting positions only. If you are long you can only sell, and if you are short you can only buy. This policy is aimed at reducing speculation and does not favor longs or shorts. You are just not allowed to add to your current position either long or short. As a side note, I am in favor of longs posting the full value of the contract once delivery becomes possible. In this case, if Joe is still long on April 1st then he must post the whole $35,000. And, I agree with Ted Butler, that if you are short into the delivery month you must have the gold to deliver.

Speculators are what make the futures market work. Without them there would be no markets. They provide the liquidity for the hedgers to hedge. For example, if Kodak needs to buy silver for delivery in July and it is currently January they need someone to take the other side of their trade. Speculators are the ones that will take the other side of that trade.  A producer (seller) who needs to hedge may not have to hedge until February and hedge a completely different amount. Again, the speculators make this trade possible. They provide a liquid market place at all times. Hedgers are not as flexible and hedge as business conditions warrant.

Open interest is the total amount of outstanding contracts in a given commodity. Open interest in gold is approximately 220,000 contracts, which represents about 22 million ounces of gold. Since there is an above ground supply of gold of around 4 billion ounces, the open interest does not represent a ridiculous amount of gold. Everybody will not take delivery at the same time as some crackpots have suggested. Most long speculators don't even have the $35,000 in their account to take delivery of a single contract. Even if every single long decided to take delivery at the same time the market could handle it. Prices would skyrocket and shorts would lose a lot of money, but higher prices are the best cure for higher prices. There will be sellers of physical gold as the price rises. I know there are a lot more gold derivatives outstanding in the over the counter market, but that has nothing to do with the COMEX. If anything, I am sure that the COMEX would like to have all of the business instead of just part of it. Unregulated derivatives aren't relevant in the decision to speculate in futures.

There is risk in any investment including treasury bills.  Yes your principal and interest are safe, but the purchasing power of your dollars is not necessarily safe. Mining stocks have a host of risks including mismanagement, nationalization of mines and heavy taxation of mines. Physical gold and silver can be stolen or the price can simply go down. There is a risk of default in the futures market, or the government can reward the winners with high taxes. Every investment has risks. Do your homework and make the best decision that you can based on what you believe will happen in the future. Don't let anybody bully or scare you into making an investment that you don't think is right.

-  Steve Kopp

-- Posted Tuesday, 21 January 2003 | Digg This Article

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