An Introduction to Precious Metals Futures Contracts

An Introduction to Precious Metals Futures Contracts 

Reading time: 8 minutes

Alongside currencies, bonds and stocks, commodities fall under the umbrella of major asset classes that are traded daily in the financial markets, either for speculation, diversifying a portfolio, or even as part of a hedge against inflationary pressures. 

The price movement of precious metals (a commodity recognised for its rarity and array of uses) and related news is covered daily by financial journalists and remains widely traded among financial market participants. Precious metals can be traded in many ways, such as in the spot market (traded for immediate delivery), in the options market (provides the holder with the right but not the obligation to buy or sell at a future date and price), as part of an Exchange-Traded Fund (ETF), or in the futures market, which is the focus of this post.  

Trading Futures: Precious Metals Futures Contracts Explored

Despite some academic textbooks overly (and often unnecessarily) complicating explanations of the futures markets, a futures contract is straightforward. 

Like a forward contract, a futures contract is an agreement to buy and sell something on a future date at a specified price. The chief difference between the two is that a forward affords more flexibility as it is traded in the over-the-counter market (OTC), while a futures contract represents a legally binding derivatives agreement that is standardised and traded on an organised exchange (much like physical shares in the stock market), such as the Chicago Mercantile Exchange, or ‘CME’. 

To simplify things further, you can think of a futures contract as a ‘standardised forward contract’: one party agrees to buy (the long position) the precious metal at a predetermined price in the future and the other party agrees to sell (the short position). Important to note is that both parties in a futures contract are obligated to transact at the delivery date or before. While futures contracts are formed using numerous underlying assets, such as Bonds, Currencies, Indices, and even Digital Currencies, precious metals are some of the most widely traded underlying assets, including gold, silver, palladium and platinum.

Several derivatives exchanges exist around the world. For example, in the US, the most famous is the CME Group, which facilitates futures and options trading and has roots as far back as the 19th century. The CBOT (Chicago Board of Trade) is another futures exchange that boasts a long and colourful history and merged with the CME Group in 2007, resulting in the CBOT adding additional products to the CME’s existing offering, including interest rates, agricultural products and equity index products. The COMEX (Commodity Exchange) and NYMEX (New York Mercantile Exchange) are two other widely popular futures exchanges that joined the CME Group in 2008; the former is concentrated on metals trading (including precious metals, base metals and ferrous metals), and the latter more on energy products, such as oil. 

The Futures Market – Key Observations:

  • Standardisation: As highlighted, futures are standardised contracts; the exchange precisely defines the terms (contract specification) to ensure transparency, listing things like the type of the underlying asset, the delivery price, the delivery date, and the details of the delivery (if the futures contract is deliverable [physically settled]); do note that precious metals futures contracts are deliverable, but some futures contracts are only cash-settled, similar to Contracts for Differences (CFDs). 
  • Counterparties: Matching up buyers and sellers is handled by the exchange. In the US, CME Clearing in the futures and options markets are the counterparties to all trades, whether you are buying or selling, and this is achieved using margin. Ultimately, this helps to mitigate counterparty risk: the risk of one party failing to meet its obligations.
  • Daily Settlement is another noteworthy component of the futures market. Unlike the forward market, where the involved parties tend to realise the payoff on the delivery date, in the futures market, all active positions are marked to market on a daily basis, which is a fancy way of saying that the exchange calculates the current value of the position based on the new futures price for that specific underlying asset and the number of contracts traded. This also helps eliminate counterparty risk.

Precious Metals Delivery?

As a trader, do I need to take delivery to trade precious metals in the futures market? No, futures contracts for precious metals are often cash-settled, meaning positions are liquidated before the contract matures. Although physical delivery is an option, it is extremely rare for independent traders and investors. 

At maturity (the expiration date), the spot price and the futures price converge to zero. Before this date, a difference between these two prices is evident (futures contract basis), with the spot price generally below the futures price (contango) given the costs associated with futures delivery (or ‘the cost of carry’).

Precious Metals Futures FAQs:

1. What are futures contracts?

Futures contracts are derivative products that allow market participants to hedge out risk exposure or assume risk (speculation). 

2. What are the key things that separate futures contracts?

Futures exchanges arrange clearing facilities between buyers and sellers. Therefore, unlike parties to a forward contract, in the futures market, the buyers and sellers of a futures contract are anonymous. The second thing is that futures contracts are standardised, and the third thing to be aware of is that there is a daily settlement in the futures market: mark to market. This helps remove counterparty risk.

3. Are precious metals physically delivered or cash settled in the futures markets?

Both. They can be either physically settled – meaning the seller delivers and the buyer accepts the physical underlying precious metal – or cash settled, which is the more popular route (this entails liquidating the position ahead of maturity). 

4. Where can I learn to read a futures quote?

You can learn to read a commodity futures quote here.

5. Where can I trade precious metals?

While you can trade precious metals in the futures or options markets and even through ETFs, you can also trade the price movement of these markets via CFDs with FP Markets. CFDs are always cash-settled and provide a cost-effective route to trading, eliminating the concern of physical delivery. 

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