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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Thursday, July 16, 2020

Gold Spot-December Futures strategy

by Century Financial in Investment Insights

Gold Spot-December Futures strategy
Gold Spot-December Futures strategy

One among the many odd events of the Coronavirus pandemic happened in the Gold markets when the spread between London spot gold and New York futures which usually trades within a few Dollars rose to near triple digits in the last week of March. It was not like the world suddenly ran out of gold, however there was a lack of gold in the desired proportions. Gold markets in London (spot price) deal in the 400 ounces bar whereas 100-ounce bars are delivered against New York futures trading in Comex. In normal times, the conversion of larger London bars into COMEX-acceptable units is a seamless process. The Coronavirus pandemic, however, forced the refineries to temporarily suspend operations and disrupted flights between many nations. This drove traders into panic as many feared that there will be a shortage of 100-ounce bars for delivery in New York and led to the surge in premiums.

With many countries now relaxing their lockdown measures, two of the world’s biggest gold refiners are almost back to pre-COVID-19 operations. Besides, Insurance firms have started covering charter flights to carry gold. The cost of transportation of Gold by chartered flight is estimated at $1 per ounce while it is reported that some Swiss refiners are charging $5 to $10 per ounce for spot supplies of kilobars. The premium for spot supplies of kilobars normally tends to be $1 per ounce. Nevertheless, even with the elevated premiums, the current spread between Gold spot and futures seem unsustainable. A spread of more than $20 is attractive for taking positions.

Currently, Gold Spot and December Futures contracts spread is trading at $29 (Futures premium to cash). The lowest in the last 1 year has been -$20 and the highest has been $70 on a daily closing basis. (Intraday high was more than $90 in the month of March). As can be seen in the charts, the spread took resistance near $35 region and is expected to contract towards the lower end of the range. i.e. Gold cash is expected to outperform Gold December futures.

Gold Spot-December Futures strategy chart

Gold Spot-December Futures strategy chart

Long cash (spot contract) and short futures strategy could be profitable if the spread narrows irrespective of price movement on the upside or downside. On the other hand, it could result in losses, if the spread widens further. If the spread breaks the near-term resistance of $36, it can potentially then test the next resistance of $52 in which case the trade would result in a loss of nearly $16000. If the spread widens to a previous intraday high of near $100 it would result in a loss of $40,000.

Price
Quantity
Exposure
Gold Cash $1,807 500 $903,500
Gold December $1,836 500 $918,000
Spread $29
Probable Gain if spread reduces to 0 $14,500
Holding rate -1.50%
Daily holding charge -$37.13
Total holding charge till expiry (27 Nov 2020) -$4,975
Probable return if spread reduces to 0 $9,524

Product idea example

Risks & Assumptions:

There is always a possibility that futures and spot prices might not converge, as that has happened in the past. Considering high volatility in markets, $75K should be maintained in the account, as per the above illustration. Additional funding might be required if the spread widens beyond $100. With US elections around in November there is always a possibility for the spread to widen to $150 resulting in further losses and additional funding.

Holding rate is currently at 1.5% and can change in the future impacting the trade either negatively or positively.

The testing environment has not considered transaction or any other costs.

Returns may vary if there is any error in executing the trades.

Data Source: Bloomberg

Arun Leslie John
Chief Market Analyst

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