Hedging Against Falling Gold Prices using Gold Futures

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Contents

Hedging Against Falling Gold Prices using Gold Futures

Gold producers can hedge against falling gold price by taking up a position in the gold futures market.

Gold producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of gold that is only ready for sale sometime in the future.

To implement the short hedge, gold producers sell (short) enough gold futures contracts in the futures market to cover the quantity of gold to be produced.

Gold Futures Short Hedge Example

A gold mining company has just entered into a contract to sell 10,000 troy ounces of gold, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of gold on the day of delivery. At the time of signing the agreement, spot price for gold is USD 851.00/oz while the price of gold futures for delivery in 3 months’ time is USD 850.00/oz.

To lock in the selling price at USD 850.00/oz, the gold mining company can enter a short position in an appropriate number of NYMEX Gold futures contracts. With each NYMEX Gold futures contract covering 100 troy ounces of gold, the gold mining company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the gold mining company will be able to sell the 10,000 troy ounces of gold at USD 850.00/oz for a total amount of USD 8,500,000. Let’s see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards or downwards by delivery date.

Scenario #1: Gold Spot Price Fell by 10% to USD 765.90/oz on Delivery Date

As per the sales contract, the gold mining company will have to sell the gold at only USD 765.90/oz, resulting in a net sales proceeds of USD 7,659,000.

By delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 765.90/oz. As the short futures position was entered at USD 850.00/oz, it will have gained USD 850.00 – USD 765.90 = USD 84.10 per troy ounce. With 100 contracts covering a total of 10000 troy ounces, the total gain from the short futures position is USD 841,000

Together, the gain in the gold futures market and the amount realised from the sales contract will total USD 841,000 + USD 7,659,000 = USD 8,500,000. This amount is equivalent to selling 10,000 troy ounces of gold at USD 850.00/oz.

Scenario #2: Gold Spot Price Rose by 10% to USD 936.10/oz on Delivery Date

With the increase in gold price to USD 936.10/oz, the gold producer will be able to sell the 10,000 troy ounces of gold for a higher net sales proceeds of USD 9,361,000.

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However, as the short futures position was entered at a lower price of USD 850.00/oz, it will have lost USD 936.10 – USD 850.00 = USD 86.10 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces of gold, the total loss from the short futures position is USD 861,000.

In the end, the higher sales proceeds is offset by the loss in the gold futures market, resulting in a net proceeds of USD 9,361,000 – USD 861,000 = USD 8,500,000. Again, this is the same amount that would be received by selling 10,000 troy ounces of gold at USD 850.00/oz.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the gold seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling gold prices while still be able to benefit from a rise in gold price is to buy gold put options.

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In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

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Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Gold Prices using Gold Futures

Businesses that need to buy significant quantities of gold can hedge against rising gold price by taking up a position in the gold futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of gold that they will require sometime in the future.

To implement the long hedge, enough gold futures are to be purchased to cover the quantity of gold required by the business operator.

Gold Futures Long Hedge Example

A goldsmith will need to procure 10,000 troy ounces of gold in 3 months’ time. The prevailing spot price for gold is USD 851.00/oz while the price of gold futures for delivery in 3 months’ time is USD 850.00/oz. To hedge against a rise in gold price, the goldsmith decided to lock in a future purchase price of USD 850.00/oz by taking a long position in an appropriate number of NYMEX Gold futures contracts. With each NYMEX Gold futures contract covering 100 troy ounces of gold, the goldsmith will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the goldsmith will be able to purchase the 10,000 troy ounces of gold at USD 850.00/oz for a total amount of USD 8,500,000. Let’s see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards or downwards by delivery date.

Scenario #1: Gold Spot Price Rose by 10% to USD 936.10/oz on Delivery Date

With the increase in gold price to USD 936.10/oz, the goldsmith will now have to pay USD 9,361,000 for the 10,000 troy ounces of gold. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 936.10/oz. As the long futures position was entered at a lower price of USD 850.00/oz, it will have gained USD 936.10 – USD 850.00 = USD 86.10 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces of gold, the total gain from the long futures position is USD 861,000.

In the end, the higher purchase price is offset by the gain in the gold futures market, resulting in a net payment amount of USD 9,361,000 – USD 861,000 = USD 8,500,000. This amount is equivalent to the amount payable when buying the 10,000 troy ounces of gold at USD 850.00/oz.

Scenario #2: Gold Spot Price Fell by 10% to USD 765.90/oz on Delivery Date

With the spot price having fallen to USD 765.90/oz, the goldsmith will only need to pay USD 7,659,000 for the gold. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 765.90/oz. As the long futures position was entered at USD 850.00/oz, it will have lost USD 850.00 – USD 765.90 = USD 84.10 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces, the total loss from the long futures position is USD 841,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the gold futures market and the net amount payable will be USD 7,659,000 + USD 841,000 = USD 8,500,000. Once again, this amount is equivalent to buying 10,000 troy ounces of gold at USD 850.00/oz.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the gold buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising gold prices while still be able to benefit from a fall in gold price is to buy gold call options.

Learn More About Gold Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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Featuring views and opinions written by market professionals, not staff journalists.

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The recent Alchemist includes an interesting article about hedging. Should mining companies hedge their gold production? Or should we use gold as hedge? Of course, we should. But against what? The WGC argues that the yellow metal is a hedge against emerging market risk. Is it true?

Hedging on the Up

As usual, there are several interesting articles in the latest issue of the LBMA’s Alchemist, which cover themes ranging from history of Bundesbank’s gold reserves to gold mining in Australia, or memoirs of important people for the gold industry, etc.

However, the most important article is about the hedging by Sean Russo and Dave Rowe. What is it? Well, gold producers can hedge against falling gold prices by shorting gold futures contracts to lock in a future selling price.

The benefits of hedging are clear: it hedges against the bear market in gold. Moreover, hedging allows entrepreneurs to access debt to develop mines, as selling some future production raises money today. It can also help the gold mining companies to smooth out changes in the gold market by securing margins to work their balance sheet harder.

The drawback of the hedging is that gold producer would have gain more without the hedge during the bull market and rally in gold. However, as the author argues, hedging it’s “about securing margins to work their balance sheets harder, not punting on the gold price.

The heyday of hedging was in the 1990s, when gold remained in a prolonged bear market and companies such as Barrick Gold Corporation hedged millions of ounces of future production to lock in profitability at their operations. At its height in December 1999, more than 3,000 tons of gold were hedged.

But as gold prices started to rise in 2001, hedging showed its ugly face. With the price of the yellow metal far above the levels at which companies hedged, the industry’s hedging liability became bigger and bigger, pushing many produces into serious troubles. The rising gold prices made hedging unpopular. The ultra low interest rates and the availability of debt funds which came after the Great Recession have also contributed to lower levels of hedging. The global hedge book amounts currently to around 7.5 million ounces of gold. However, the strategy is gaining on popularity, allowing producers to reduce debt and providing them with more predictable revenue streams. Luckily, the current hedging is not like the hedging done in the 1990s, but it’s more disciplined and more limited in size (on average, only six months worth of production is hedged). Thus, even if the gold prices move higher, it shouldn’t significantly impact the mining companies.

Using Gold to Hedge Emerging Market Risk

While Alchemist focuses on hedging by gold producers, the World Gold Council, in its May Investment Update, analyzes the use of gold as a hedge against the emerging market risk. The report starts with the observation that rising interest rates in the U.S. could cause uncertainty and hurt the attractiveness of exposure to the emerging market risk. Luckily, “as gold often acts as a safe haven and hedge against systemic risks, it can provide an appropriate hedge to EM exposure.” The WGC also argues that gold provides a hedge against foreign-exchange risk at a lower cost than traditional currency hedges.

However, we don’t agree. Both gold and emerging market currencies suffer when the U.S. dollar rallies, so we are skeptical about the idea of adding gold to the portfolio with EM currency exposure. To be clear: we strongly support the idea of having precious metals in investment portfolio, but not because they hedge against emerging market risks.

This is not true. Gold does act as a safe haven against systemic risks, but emerging markets are not systematically important. It may be considered sad that investors don’t care about developing countries, but this is a reality. You seen, all animals are equal but some animals are more equal than others. Similarly, all markets are important but some markets are more important than others. And gold also often shrugs off what is happening in emerging markets – the Asian Financial Crisis being the best example. On the contrary, gold is very sensitive to the developments in the EU, Japan and primarily in the U.S., as the yellow metal is the bet against the U.S. dollar.

If you enjoyed the above analysis, we invite you to check out our other services. We provide detailed fundamental analyses of the gold market in our monthly Market Overview reports and we provide daily Gold & Silver Trading Alerts with clear buy and sell signals. If you’re not ready to subscribe yet and are not on our gold mailing list yet, we urge you to sign up. It’s free and if you don’t like it, you can easily unsubscribe.

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