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How to Trade Gold
Futures in India
The price of gold
depends on a host of factors, which makes it very difficult to predict. In a
fashion similar to shares, gold is an asset class by itself. In fact, in many
villages and small towns of India, gold is preferred to bank deposits as a
savings and investment instrument.
Till a year ago, to
gain from price volatility, one would have to hoard and trade in gold
physically. Not any more, however. With the commodity futures market operating
in full swing, one has the option of not physically stocking gold to gain from
its price movements.
Let us see how trading
in futures is better than the option of hoarding gold. Firstly, there are
several costs associated with the process of physically stocking gold. The costs
include the cost of the gold itself, the cost of carrying, cost of physical
storage, finance cost and last, but not the least, the safety element.
While futures might
have some advantages, there is also a danger of losing big as your risks are
also magnified and hence, one must tread carefully in this area.
In this context, if the
going cost of gold is Rs 6000 per 10 grams, with an investment of Rs 6 lakh, one
can buy 1kg of gold. Now, suppose, three months hence, when the going price of
gold is Rs 6,500 per 10 grams, the person decides to sell the gold. The gross
profit made by the person is Rs 500 for every 10 grams and hence, for 1 kg, it
stands at Rs 50,000. To arrive at the net profit, one would have to deduct the
cost of financing; the cost of storage in a bank and transaction costs,
including sales taxes.
Now, let’s see what the
same Rs 6 lakh can achieve in a futures market, assuming the same sequence of
prices. In Indian exchanges, currently, futures contracts up to four months are
available. Let’s assume that three-month gold futures are trading at a little
over the spot price, with the market expecting gold prices to remain stable over
the next three-month period. Let this price be Rs 6050.
Since a futures
contract is an obligation to buy or sell a specific quantity of the commodity,
one does not have to pay for the entire value of the commodity. Buying futures
obligates one to take delivery of the underlying commodity at a particular date
in the future. This is also known as taking a long position.
To trade in gold
futures, one has to go to a brokerage house and open a trading account. A
trading account involves keeping an initial deposit of Rs 50,000 to Rs 1 lakh.
Part of the money accounts for the margin money, which is required by the
exchange when one enters trading.
For a high amount,
however, the deposit amount is usually waived by the brokerage house. The whole
investment is then generally treated as margin money. For commodity futures,
there is usually a lot size or the minimum volume of the commodity of which one
has to buy a futures contract.
Let’s assume, for our
case, the minimum lot size is 1 kg (lot sizes are usually 100gm or 1 kg). Thus,
if the going futures rate is Rs 6,050 per 10 grams, the minimum value of a
contract is Rs 6,05,000. The beauty of a futures contract is that to trade in
them, one has to only invest the margin money. If we assume a flat 5% margin
rate for the contract (margin rates vary from 5-10%), the margin money for a
single lot is Rs 30,250. Add to that, a brokerage amount, which is usually .1%
to .25% and some start-up charges. Applying these rates, which are prevalent in
the market currently, a single lot of gold futures contract should come at
around Rs 32,000.
Thus, with Rs 6 lakh,
one can buy 19 lots of gold futures. One can , however, expect ‘margin calls’
from brokerage houses if the margin money falls short of the margin money
required for trading in the exchange, determined at the end of the trading
session each day.
Now, suppose that at
the end of 3 months, the spot price of gold actually reaches Rs 6,500 per 10
grams.
The novelty of the
futures market is that as long as there is sufficient liquidity in the markets,
the futures price always converges to the price of the under lying. Such is the
leverage of futures, that with the same investment of Rs 6 lakh, one is actually
commanding 19 lots of gold futures or in effect, 19 kgs of gold.
Thus, at the end of
three months, assuming the above-mentioned course of events, on an investment of
Rs 6 lakh, one can make a gross profit that is almost 17 times the profit made
by physically stocking gold.
At the same time, the
downside risk is also multiplied. To avoid the hassles of delivery, one must
offset the futures contract just before the maturity date is reached. Delivery
would entail gold certification and accreditation by an exchange-appointed
assayer and increased transaction costs in general, as various taxes come into
the reckoning.
The above example is
about a case of taking a bullish view on the price of gold and hence, gaining
from the price rise by buying futures. One can gain from a futures market even
by having a bearish view on the price of gold. This aspect of gain is absent in
the physical market for gold. If one believes that the spot price of gold is
going to fall in the near future, all he needs to do is to sell gold futures.
While all this seems
pretty rosy, there are some things to be kept in mind. Firstly, any transaction
in the futures market is possible only if a counter-party to the buy or sell
order that is placed, exists. For unusually large investments, the exchange may
find it difficult to find a counter-party and so it may take some time to match
it. Also, with any futures, there may be a problem in exiting from a position by
buying or selling when one would like to. |
