Gold derivatives are financial instruments linked to the price of gold, offering investors flexible ways to participate in the gold market without owning physical gold. Gold futures and options contracts, traded on exchanges like COMEX, enable speculation and hedging based on future gold prices. Exchange-traded funds (ETFs) backed by physical gold provide a simple and accessible way for investors to track gold's performance. Gold swaps and forwards facilitate customized hedging and financing strategies by allowing participants to exchange cash flows tied to gold prices. In the intricate world of gold derivatives, investors can manage risk, speculate on price movements, and fine-tune their gold exposure to align with specific financial objectives.
Gold derivatives often have complex or hidden costs and risks associated with them. Physical gold bullion is competitive in its price structure and has no contractual risk (also known as counter-party risk). Gold ETFs are one of the most popular gold derivative products and illustrate the point perfectly. Assuming an investor places $10,000 into their investment the first year and $5,000 each thereafter, we can calculate the cost of the ETF over time based on the expense ratio. For comparison’s sake, we’re assuming the ETF always performs as well as spot gold, which isn’t always true.
Average Gold ETF | |||
Years | Net Investment | ETF fees | Physical Gold Premium (est. 5%) |
10 | $55,000.00 | $4,035.05 | $2,750.00 |
15 | $80,000.00 | $10,550.93 | $4,000.00 |
20 | $105,000.00 | $23,047.12 | $5,250.00 |
25 | $130,000.00 | $45,482.45 | $6,500.00 |
30 | $155,000.00 | $84.124.96 | $7,750.00 |
This table illustrates how the fees for gold derivatives add up and exceed the cost of physical bullion over time.
Gold Price History
Highest Gold Price Ever Achieved:
Gold's current record high was achieved on July 16th, 2024, at $2,483 per troy ounce. This follows a trend of new record setting highs for gold in recent history. A new high was reached on August 7, 2020, when it surpassed $2,074 per ounce. This remarkable milestone was primarily driven by a combination of factors, including the economic uncertainty caused by the COVID-19 pandemic, low-interest rates, a weakening U.S. dollar, and increased demand for safe-haven assets. Just a short few years later, another new high was reached on May 4, 2023, when gold hit $2,080.72. This was sparked by demand fueled by the collapse of Silicon Valley Bank, as wealthy investors rushed to get their money out of banks at risk of failure and into gold. As the FDIC only insures up to $250,000 per account, someone with considerably more money in the banking system stood to lose a lot of money. After SVB’s collapse, several other high-profile banks failed. In general, catastrophe tends to spur demand for safe-haven assets like gold, which leads to stronger prices. Another new record was established just seven months later on December 3rd, 2023 of $2,135 per troy ounce. In this case, one of the board members of the Federal Reserve made remarks to the public that indicated rate cuts may be imminent in 2024. The potential of lower interest rates makes gold attractive because it serves as a hedge against inflation and offers a lower opportunity cost when yields on other investments decrease.
Gold then passed record highs multiple times, driven by expectations of rate cuts with rallies coinciding with FOMC announcements or favorable readings from economic reports. For example, the March FOMC meeting in 2024 forecasted three rate cuts to the federal funds rate in 2024. This spurred gold to a new all-time high on March 20th to $2,220. Market players optimistically bought gold in anticipation of future rate cuts in the near term, driving up the spot price to new all-time highs. This bull run continued until May 20th, 2024 when spot gold peaked at $2,450 per troy ounce as investors reacted to the death of Iran's President, who perished in a helicopter accident during a period of heightened tensions in the Middle East. The most recent price peak followed a period of consistent growth amidst confidence of a rate cut in September 2024 before hitting the current all-time high of $2,483 on Tuesday, July 16th. This record setting price followed an assassination attempt on former U.S. president Donald Trump, which occurred on Saturday, July 13th.
Gold Price Appreciation Over Time:
Gold has demonstrated an average annual rate of return of approximately 7.78% over the long term. This number is achieved by looking at gold’s prices from 1971 to 2022.
Using All-Time Highs for Timing:
Many investors monitor how close the current gold price is to the all-time high as a timing tool. When gold approaches or surpasses its historical peak, some investors view it as a signal to consider selling, anticipating a potential correction. Conversely, others see it as an opportune moment to buy, betting on a continuation of the upward trend. When important psychological thresholds are breached, such as a new all-time high being set, it opens the possibility for a larger, more protracted upward movement in gold prices. However, it's essential to consider the broader economic and geopolitical context before making investment decisions solely based on historical price highs.
Factors That Influence Gold Prices
Several key factors play a pivotal role in determining the price of gold. These factors include:
- Economic Conditions: The state of the global economy, inflation rates, interest rates, and overall financial stability all influence gold prices. During times of economic uncertainty or inflationary pressure, gold tends to rise in value as a safe-haven asset.
- Geopolitical Events: Political instability, conflicts, and trade tensions can significantly impact gold prices. Investors often flock to gold as a safe-haven asset during times of geopolitical turmoil.
- Currency Movements: The value of the U.S. dollar has an inverse relationship with gold prices. A weaker dollar typically leads to higher gold prices, as gold becomes more attractive to international investors.
- Central Bank Policies: The buying and selling of gold by central banks can affect prices. Large-scale purchases or sales by central banks can have a substantial impact on the supply and demand dynamics of the gold market.
- Supply and Demand: The balance between gold supply and demand, influenced by factors like mining production and jewelry consumption, plays a role in price fluctuations. Scarcity or excess supply can lead to price shifts.
- Investor Sentiment: Market sentiment and speculator behavior can drive short-term price movements. Events, news, and market sentiment can lead to rapid price swings.
- Technical Analysis: Traders often use technical indicators and charts to make short-term predictions about gold price movements. These include moving averages, support and resistance levels, and other technical patterns. Some algorithmic trading patterns have been created to automatically trade on technical analysis, adding to complexity in the market.
How Gold Spot Prices are Determined
Spot prices for gold are determined through a globally coordinated process overseen by the London Bullion Market Association (LBMA). The LBMA sets the standards for gold trading and conducts electronic auctions, most notably the LBMA Gold Price, twice daily. During these auctions, market participants, including banks, refiners, and institutional investors, submit buy and sell orders until a supply and demand equilibrium is reached, establishing the spot price. International factors, such as currency exchange rates and global economic events, can also influence these prices, making gold a 24/7 traded commodity. Real-time transparency is provided, ensuring that investors have access to accurate and up-to-date spot prices, facilitating well-informed trading and investment decisions.
The determination of gold spot prices also involves other major exchanges, notably the COMEX (Commodity Exchange, Inc.), in addition to the LBMA. While the LBMA plays a crucial role in setting global standards and benchmark prices, COMEX, a division of the CME Group, is prominent in gold futures and options trading. The prices established on COMEX, particularly the most actively traded futures contracts, influence spot prices. These futures contracts provide a forward-looking view of market expectations and can affect spot prices due to their significant trading volumes and liquidity. As a result, the interaction between the LBMA's spot prices and COMEX's futures prices creates a dynamic relationship, impacting the overall price discovery process for gold in the global marketplace. Other exchanges involved in the price discovery process include the Shanghai Gold Exchange, the Tokyo Commodity Exchange and the Dubai Gold & Commodities Exchange.
How do Gold Futures Affect Gold Spot Prices?
Futures play a crucial role in influencing gold spot prices. These futures markets, such as COMEX, contribute significantly to price discovery for gold, providing a reference point for the prevailing spot prices. The arbitrage opportunities that arise between gold futures and spot markets lead to the convergence of prices, as traders capitalize on price disparities. Speculative activity in the futures market can influence market sentiment and trigger short-term price movements, impacting both futures and spot prices. Additionally, participants in the gold industry use futures contracts for hedging against price fluctuations, affecting the supply and demand dynamics of the spot market. The process of rolling over expiring contracts in the futures market can also trigger spot market transactions related to physical delivery obligations, contributing to shifts in supply and demand dynamics and, consequently, spot prices.
How to Trade the Gold/Silver Ratio
The gold to silver ratio represents the number of ounces of silver required to purchase one ounce of gold. This ratio offers valuable insights into the relative values of these metals. Historically, a higher ratio suggests that silver may be undervalued compared to gold, making it an opportune time to consider silver investments. Conversely, a lower ratio might indicate an advantageous moment for gold investments.
Seasoned investors will trade their silver for gold when it’s advantageous to do so, and vice versa. For example, let’s say an investor bought 5 ounces of gold in January 2019 when the gold to silver ratio was 82. That investor who was trading the ratio may have seen an opportunity to exchange his gold for silver in April or May of 2020 at a ratio of 112. That would give the investor 560 ounces of silver. Later, in September of 2020, the gold to silver ratio dropped to 70. Trading this ratio again would allow the investor to trade his 560 ounces of silver for 8 ounces of gold. In January of 2019, that investor may have been able to purchase gold for approximately $1300/ounce, meaning that by September of 2020, those five ounces becoming eight ounces would put his average cost per ounce of gold at $812.50. Gold in September of 2020 was over $1900/ounce, meaning the investor trading this ratio during that time would have seen excellent returns over 133%.
This scenario does not consider the effects of tax, premiums or the investor making advantageous or disadvantageous trades. In most cases the individual investor trading the gold to silver ratio will be unable to barter and will need to convert to a liquid currency like the US dollar to trade.
Why Gold is a Good Diversifier
Gold is a perennial favorite among seasoned investors for diversifying their portfolios. Unlike many other assets, gold often moves independently of traditional financial markets, offering a safe haven in times of stock market turbulence or currency devaluation.
Diversification is the cornerstone of sound investment strategy. It spreads risk by allocating investments across different asset classes, reducing the potential for catastrophic losses. By including assets like gold, which tend to behave differently from stocks and bonds, you can enhance the stability of your portfolio. Gold becomes uncorrelated with other assets during market volatility, meaning when stocks are down, gold price tends to go up.
In recent years, stocks and bonds have become correlated, potentially related to the “easy money” policy of central banks over the decade or so. Defined contribution plans have educated the public for years that a mix of bonds and stocks provides diversification. But since these asset classes have begun to correlate, it undermines the diversification benefit tremendously. Meanwhile, gold has not correlated with either asset and tends to experience demand while stocks are stressed.
Gold and Local Currencies
Global exchanges, such as COMEX and the LBMA, can influence gold prices in local currencies. The most direct impact occurs through exchange rates, where changes in the international gold price lead to corresponding adjustments in the value of gold in local currencies. A stronger global gold price typically results in higher gold prices in local currencies, while a weaker global price can lead to lower local prices. Import and export dynamics also play a role, with international price disparities encouraging trade activities that affect local prices.
Investor behavior is another significant factor, as global price trends and market news can influence local demand for gold and subsequently local prices. Finally, arbitrage opportunities may arise when substantial price differences exist between global and local markets, allowing traders to buy low and sell high, thus narrowing the price gap and bringing global and local prices into alignment. These influences collectively contribute to the intricate relationship between global exchanges and gold prices in local currencies.
A good example of this is Shanghai in 2023, where domestic production waned after the pandemic, local demand surged, and the government placed import restrictions on gold. Gold prices there increased as gold became a relatively scarcer commodity. However, due to government restrictions, arbitrage opportunities have not been readily apparent, which is why price equilibrium with the global gold market has been elusive.
Gold and the US Dollar
Gold is traded in the US Dollar and quoted in USD. This is partially why a correlation exists between the USD and Gold prices. When the US dollar is weak, gold prices tend to move upwards, and when the US dollar is strong, gold prices tend to decline. However, there are many factors influencing gold prices, and the correlation is not perfect. There will be times when the US dollar is surging and gold experiences similarly strong prices. The FX ticker for gold is XAU/USD. This is sometimes confused the Philadelphia Gold and Silver Index, which is an index of thirty gold and silver miners listed on the NASDAQ and has a stock ticker symbol of XAU.
How are FOREX Traders Finding Arbitrage Opportunities in Gold Markets Worldwide?
FOREX traders identify arbitrage opportunities in gold markets through various strategies. They exploit price disparities between different markets and currencies, engaging in cross-currency arbitrage by buying gold in a cheaper currency and selling it where it's more expensive. Additionally, they can leverage spot-futures arbitrage by capitalizing on significant deviations between gold's futures and spot prices. Traders also explore intermarket arbitrage, profiting from variations in different gold markets, including the LBMA, COMEX, and local exchanges. While arbitrage can yield profits, traders must be mindful of transaction costs, exchange rate fluctuations, and market liquidity, acting swiftly to seize short-lived opportunities before they vanish.
Why is Gold Used as a Store of Wealth?
Gold has traditionally been used as a store of wealth for thousands of years. A roman who buried an ounce of gold in 100 A.D. could have used that gold to buy a nice toga. Almost two thousand years later, one can use an ounce of gold to buy a nice suit, and have money left over. The analogy has been used by many gold investors over the years to illustrate that in the long run gold has held its value tremendously well and in a manner that most assets cannot. This is why gold is considered a hedge against inflation, and why long term investors ignore short term price swings in gold spot prices.
Why You Should Never Attempt to Buy Gold Below Spot Price
Like many industries, there are people who attempt to take advantage of others. If an offer sounds too good to be true, trust that it is. Someone who is attempting to sell a troy ounce of gold under spot is likely selling a fake gold coin or gold bar.
The spot price represents the value of the metal, but the premium is a necessity for the entire supply chain to stay in business. The premium pays for the mines, refiners, mints, and retailers to stay in business and make a profit. Without a premium, the metal stays in the ground and no market can exist. If you see gold listed below spot price, it’s best to default to suspicion.
