What is the COMEX Futures & Options market really all about?Tuesday April 19, 2016 14:54
Let’s take a deep look into COMEX in this article that describes COMEX today.
All of us follow COMEX in New York and assess the ‘net speculative long position’ there, so as to see the actual weight of opinion on the gold price. It gives us a clear market opinion, after all. But many of you out there may believe that COMEX is a very large factor in the gold price. Should it be?
It would be easy of us or any other commentator to give their opinion on the matter, but would that be enough to be absolutely right? So as to not give an opinion, we felt it important to go direct to COMEX to get the proper story. We spoke to the Director of Metals Products in the COMEX Marketing Dept. This is what COMEX says;
What you may have thought about COMEX
It may seem reasonable to you to assume that the ‘net’ position on COMEX would be covered by COMEX actually ensuring that this amount of gold or silver is held in one of their four COMEX approved depositories that are all located in New York city. After all, delivery of the gold and silver is effected via electronic warrant.
This would reassure us that COMEX dealings did affect the gold or silver price, would it not? After all, supposing someone went short and could not deliver, who would supply the metals? The implications are that COMEX is constantly adjusting their gold & silver holdings to make sure that no-one would be left without the metal they bought there. Not so!
What really happens?
The exchange in no way determines the price....we only report it.
Conclusion on COMEX
The long and short of it is that COMEX is simply a ‘cash’ market that does not deal in gold or silver or other items at all. They simply provide a’ cash’ market where risks are laid off. Yes, physical dealers in gold and silver may well use the market to ‘hedge’ opposing real physical positions so that they don’t face a price risk and yes, traders [or gamblers] use the market to take leveraged, speculative positions that are in no way backed by the physical possession of the metals.
To see how a true “Hedger” uses COMEX see the experience below of one trader protecting himself and profiting by the sound use of COMEX
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How a true Hedger acts
Many investors are puzzled by the importance of the COMEX Options & Futures markets on the price of gold.
Take a look at the Diagram here [to enlarge it put your cursor on the corner and pull it diagonally] and you see that 86% of trading in gold Futures and Options takes place in London and New York.
Many may well believe that this translates into 86% of trading in gold [physical gold] takes place in these two centers. But this is not correct. The best way to illustrate this is to give you an example of a company that manufactures gold jewelry, as its main business.
This company needs to take delivery of a tonne of gold for the manufacture of jewelry between September and the November and then deliver it to retail jewelers. Its business is manufacturing only, but it finds itself at the mercy of a constantly moving gold price. These moves can be large enough to destroy profit margins.
The company cannot afford to suffer the risks on the gold price.
It is at this point that they need to turn to the COMEX Futures & Options to lose the risk of the gold price.
The head of the jewelry manufacturing company decides on when they enter the contract to buy the needed 1 tonne of physical gold. This may be at a time well ahead of September, the delivery date. He may believe that the price he can buy for is the lowest price he will see before September. So he goes ‘long’ of one tonne of physical gold just as he needs to be, so he can take delivery in September to get on with the business he is in. He does this by buying it on a bullion market, or from a refinery, or a bullion dealer.
But can he afford to take such a risk with such a changing price in gold? The price may drop before then and he is left with a cost that may prove too much for his business.
So he ‘hedges’ by selling a tonne of ‘paper’ gold on the Futures market. Now he hasn’t ‘zero’ positions, but one physical long and one short hedge position, but zero risk, as any losses he makes on one position will be covered by profits on the other position.
Now the price drops horribly. He then believes it has gone far too low, so he buys another tonne of paper gold on the Futures market and makes a profit [technical] from his short position. Now he is left with his original physical long physical position, a ‘hedged’ short position and a new long position. The effect of his profits on his short position has left him, in effect, with a much lower price on his physical long position.
But he has a risk position, nevertheless, as the net position is; two long and one short. But netting out these is what he started with. So now the manufacturer still wants to cover his risk, although his net price is lower than the price he originally paid.
He is willing to open another short position to remove all risks if the price rises again. The price then rises again so he does open a new short position. Now he has four positions, three of which are in the Futures market. Each time he makes a ‘profit’ on matching positions, in effect he lowers his entry price.
He is not speculating, in the modern sense of the word, as the only risk he really takes is on the original physical position.
It is not uncommon for such a hedger to have 50 plus positions against the original exposure. He doesn’t need a large change in price to continue increasing his positions. The reason it is not so speculative is that his original position needed hedging and subsequent actions are only undertaken when a profit is sure.
A speculator takes a view on the price itself with no underlying motive except price direction. He usually exposes himself to high risk that remains uncovered. Frequently, such traders take losses. We questioned one trading house, who informed us that even amongst professional speculators the success rate was only 52% at best amongst amateurs.
This example helps one to understand that COMEX is not about gold supply and demand, simply about price. It is a money market separate from the gold market or the pork belly market.
It serves a vital function, but should not lead the gold price but follow it.
Now look at the diagram we featured here once more.
By Jullian D. W. Phillips