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Futures contain a built in price differential to account for the financing cost

Before a salesman tells you that buying a future saves you interest it is important to understand the implicit financing cost in a futures price.

A gold futures contract will almost always be priced at a different level to spot gold.  The differential closely tracks the cost of financing the equivalent purchase in the spot market.

Because both gold and cash can be lent (and borrowed) the relationship between the futures and the spot price is a simple arithmetical one which can be understood as follows:

"My future purchase of gold for dollars delays me having to pay a known quantity of dollars for a known quantity of gold. I can therefore deposit my dollars until settlement time, but I cannot deposit the gold - which I haven’t received yet. Since dollars in the period will earn me 1%, and gold will only earn the seller who's holding on to it for me 0.25%, I should expect to pay over the spot price by the difference 0.75%. If I didn't pay this extra the seller would just sell his gold for dollars now, and deposit the dollars himself, keeping an extra 0.75% overall.  Clearly this 0.75% will fall out of the futures price day by day, and this represents the cost of financing the purchase."

This means that when you buy a future you are paying for the cost of financing the entire purchase.  In addition, although much less significant, because almost all brokers take the margin you put down into their own account, you are - in effect - paying the financing cost twice on this fraction of the contracted sum.

Rollover applies acute psychological pressure

As a futures contract ends an investor who wants to keep the position open must re-contract in the new period by 'rolling-over'. This ‘roll-over’ has a marked psychological effect on most investors.

Having taken the relatively difficult step of taking a position in gold futures investors are required to make repeated decisions to spend money.  There is no ‘do nothing’ option, like there is with a bullion investment, and rolling over requires the investor to pay-up, while simultaneously giving the opportunity to cut and run.

The harsh fact of life is that if investors are being whip-lashed by the regular volatility which appears at the death of a futures contract many of them will cut their losses.  Alternatively they might attempt to trade cleverly into the next period, or decide to take a breather from the action for a few days ('though days frequently turn into weeks and months).  Unfortunately every quarter lots of investors will fail the psychological examination and close their position.  Many will not return. The futures markets tend to expel people at the time of maximum personal disadvantage.

Costs - as a percentage of principal

When a future is traded the broker will frequently compute dealing costs as a percentage of the principal.  This is deceptive. 

The principal has not actually been settled, so the costs of settlement - where most of the real expense lies - have not been borne.  The expense in a future is the cost of taking out a notional promise, which one should expect to be pretty low.  It is sneaky to quote a percentage on the basis of an irrelevantly large principal when the costs of settling that amount have yet to be added.  Were it instead computed as the percentage of the margin - a more relevant figure - futures would look like substantially more expensive instruments to trade.

The stop-loss

Many futures broking firms offer investors a stop loss facility. It might come in a guaranteed form or on a 'best endeavours' basis without the guarantee. The idea is to attempt to limit the damage of a trading position which is going bad.

The theory of a stop loss seems reasonable, but the practice can be painful. The problem is that just as trading in this way can prevent a big loss it can also make the investor susceptible to large numbers of smaller and unnecessary losses which are even more damaging in the long term.

On a quiet day market professionals will start to move their prices just to create a little action. It works. The trader marks his price rapidly lower, for no good reason. If there are any stop losses out there this forces a broker to react to the moving price by closing off his investor's position under a stop loss agreement. In other words the trader's markdown can encourage a seller. The opportunist trader therefore picks up stop loss stock for a cheap price and immediately marks the price up to try and 'touch off' another stop loss on the buy side as well. If it works well he can simulate volatility on an otherwise dull day, and panic the stop losses out of the market on both sides, netting a tidy profit for himself.

It should be noted that the broker gets commission too, and what's more the broker benefits by being able to control his risk better if he can shut down customers' problem positions unilaterally. Brokers in general would prefer to stop loss than to be open on risk for a margin call for 24 hours.

Only the investor loses, and by the time he knows about his 'stopped loss' the market - as often as not - is back to the safe middle ground and his money is gone.

Without wishing to slur anyone in particular the stop-loss is even more dangerous in an integrated house - where a broker can benefit himself and his in-house dealer by providing information about levels where stop-losses could be triggered. This is not to say anyone is doing it, but it would probably be the first time in history that such a conflict of interest did not attract a couple of unscrupulous individuals somewhere within the industry.

Investors can prevent being stopped out by resisting the temptation to have too big a position just because the futures market lets them. If the investment amount is lower and plenty of surplus margin cover is down, a stop loss is unnecessary and the broker's pressure to enter a stop loss order can be resisted. A conservative investment strategy with smaller positions achieves the goal of avoiding catastrophic losses by not keeping all eggs in one basket. It also avoids being steadily stripped by stop loss executions. On the flip side you cannot get rich quickly with a conservative investment strategy (but then the chances of that were pretty small anyway).

Hidden costs at the close and/or rollover

Each quarter a futures investor receives an inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced rate.  To those who do not know the short term money rates and the relevant gold lease rates - or how to convert them into the correct differential for the two contracts - the price is fairly arbitrary and not always very competitive.

It can be checked - but only at some effort.  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%.

But there are strange extra forces at work.  They come from predictable facts about the distribution of gold futures positions :-

Suppose the old future is fairly priced at 100.  The normal spread is - we'll say - 0.20%.  So a typical roll-over - 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). There would also be commission on top, but that is not hidden.

That 0.63 of the differential represents the financing cost of the entire principal for the new period (described above).

In addition the trader can improve his profitability, because of the different profiles of longs and shorts.  What he does is anticipate the likely direction of a random customer who contacts him, and the nearer the end of the period the more the odds are stacked that whoever is on the phone 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.

The trader artificially lowers both his trading price, and his liquidity.  The quote becomes 99.825 - 100.655 (remember the 0.63 of finance cost) sized in one lot, not ten.

It seems to the casual eye that there is still a 0.2% 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 big buyer has to execute three trades (at different prices) to buy what he wants to close.

+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
+1 old -99.825
-1 old (bigger customer wants to do 10) +100.655
-4 old (adjusted price on larger purchase order) +100.73
-5 old (adjusted price again to complete larger purchase order)  +100.755

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 100.735.  It might look like a trading spread of 0.2% when it's quoted (without the financing cost) but it's actually 0.38%.  The trader's profit has increased by 90% because of his successful anticipation of the distribution of orders, and 10 private investors' profit has diminished by 0.075%.  Exactly the same thing happens on the purchase side in the new futures period.  So in effect, on a trade which is commissioned at only $10 for the pair the actual cost hidden in rollover spreads is $40,000 * 0.0038 - or $152 on each leg! 

(Please note - these figures are an illustration.  It is very hard to compute the reality, because private investors do not usually know the traders' end of the equation or the implied financing cost.  Nevertheless the object of the example is to show a potentially substantial and opaque cost which dwarfs the 'low' commission.  Both accrue to the trader. Private futures speculators have felt the result when they notice that while the spot price doesn't seem to have moved much, for some reason the futures position is costing money to keep open.)

Perhaps you could rollover early to avoid the problem. If you try you'll find plenty of liquidity in the old future but hardly any in the new one. You'll fall victim to much the sort of same mechanism on the other side.

Running through to Settlement

Meanwhile the professionals are busy fixing to finance settlement - a luxury not usually available to the private investor. 

A big futures player can probably arrange a short term borrowing facility for 3% and borrow gold for 1%, whereas a private investor cannot borrow gold and might pay 12%-15% for money which prices settlement out of his reach, even if he had the storage facility and other infrastructure in place to take delivery.  The known imbalance allows a few large shorts to elect for settlement (i.e. not buying back the future to close) and this cannot easily be duplicated by the longs.  A shortage of buyers in the old futures contract develops at the death and it depresses the price for small bulls trying to sell and buy back in the new period.

How low?  Clearly there is a floor - because bigger participants will come in to snap up cheap futures selling bullion on the spot market financed by a gold loan (which keeps their book balanced overall).  But the futures 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 and physical delivery.  Trades have to be executed, matched, margined, reconciled, delivered, weighed etc, and all of this takes people, systems, time and money.  Moreover 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 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, and the profitability on transacting them is reduced. So arbitrage buying 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 the hassle of physical delivery.

All this is predictable by professionals - and it is self-justifying because it encourages more professionals, and anyone who can borrow gold cheaply (a privilege only available to big corporates) to be short at the death even if they have no specific gold view.  Private investors usually lose out.

Automatic instability

Futures markets have structural features which are not natural in markets.

In normal markets a falling price encourages buyers who pressure the price up, and a rising price encourages sellers who pressure the price down. This is relatively stable. But successful futures exchanges offer low margin percentages (of about 2% for gold) and to compensate for this apparent risk the exchange's member firms must reserve the right to close out their losing customers.

In other words a rapidly falling market can force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price, and either scenario has the potential to produce a runaway spiral. This is manageable for extremely long periods of time, but it is an inherent danger of the futures set-up.

It was virtually the same phenomenon which was paralleled in 1929 by brokers loans. The forced selling which these encouraged as markets started to fall was at the heart of the subsequent financial disaster. In benign times this structure merely encourages volatility.  In less benign times it can lead to structural failure.

The risk of systemic failure

Gold is bought as the ultimate defensive investment. Many gold buyers hope to make large profits from a global economic shock which might be disastrous to many other people. Indeed many gold investors fear financial meltdown occurring as a result of the over-extended global credit base - a significant part of which is derivatives.

The paradox in investing in gold futures is that a future is itself a 'derivative' instrument constructed on about 98% pure credit. There are many speculators involved in the commodities market and any rapid movement in the gold price is likely to be reflecting financial carnage somewhere else. Both the clearer and the exchange could theoretically find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous book profits which could not be paid as busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses.

This sounds like panic-mongering, but it is an important commercial consideration. It is inevitable that the commodity exchange which comes to dominate through good times and healthy markets will be the one which offers the most competitive margin [credit] terms to brokers. To be attractive the brokers must pass on this generosity to their customers - i.e. by extending generous trading multiples over deposited margin. So the level of credit extended in a futures market will tend to the maximum which has been safe in the recent past, and any exchange which set itself up more cautiously will have already withered and died.

The futures exchanges we see around us today are those whose appetite for risk has most accurately trodden the fine line between aggressive risk taking and occasional appropriate caution.  There is no guarantee that the next management step will not be just a bit too brave.


Succeeding in the futures market is not easy.  To be successful you need strong nerves and sound judgement.  Investors should recognise that futures are at their best for market professionals and short term speculations in anticipation of big moves which knock out the more obscure trading costs.  Above all the investor must understand the inevitable problem which occurs when a market loses its transparency.  Once a market can apply costs which are opaque and difficult to comprehend - and surely the futures market qualifies in this regard - the advantage shifts to professionals who are sophisticated enough to see through the fog.  The experience of many individuals who have tried in this market suggests that this has probably happened with gold futures.