How Precious Metals Like Gold Can Be Arbitraged

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How Precious Metals Like Gold Can Be Arbitraged

Precious metals are commodities that may be traded via a variety of securities classes, including metal trading (spot trading), futures, options, funds, and exchange-traded funds (ETFs).Gold and silver, two of the most widely traded and popular commodities for investing across the world, provide extensive trading possibilities with high liquidity.

Arbitrage possibilities exist in precious metals trading, just as they do in any other traded asset. This article outlines the fundamentals of precious metals arbitrage trading and gives instances of how investors and traders may earn from precious metals arbitrage.

Key Takeaways

  • Metals trading is utilizing derivatives markets to speculate on or hedge against commodity price changes such as gold and silver.
  • Because these commodities are traded on worldwide marketplaces, price mismatches in the same commodity may occur due to a number of circumstances.
  • Arbitrage is a method of profiting from these apparent mispricings with little risk.

What Is Arbitrage?

Arbitrage is the simultaneous purchase and sale of a security (or its many forms, such as stock or futures) in order to profit from the price difference between the buy and sell price (i.e. the bid and ask spread).

For example, suppose the Comex price of gold is $1,825, and bullion is traded for $1,827 on a local market. One may purchase at a cheaper price and sell at a greater price at the same time. If the possibility to arbitrate presents itself, there are several options. As an example:

Market Location Arbitrage

The difference in demand and supply of precious metals in one geographical market (location) vs another may result in a price discrepancy, which arbitrageurs aim to exploit. This is the most basic and often used kind of arbitrage.

For example, suppose the price of gold in New York is $1,850 per ounce and it is selling at GBP 1,187 per ounce in London. Assume a 1USD=0.65GBP conversion rate, which puts the dollar-equivalent London gold price $1826.15. Assume shipping from London to New York costs $10 per ounce. A trader may earn by acquiring gold in the lower-cost market (London) and selling it in the higher-priced market (New York), netting $1,850-1,826.15-10=$13.85 per ounce.

The time to delivery is a crucial issue that has not been addressed here. By air or by sea, the intended consignment may take at least a day to arrive in New York from London. The trader has the possibility of a price reduction during this transit time, which will result in a loss if the pricedips go below $1,836.

Cash and Carry Arbitrage

Cash and carry arbitrage entails constructing a portfolio of long positions in the physical commodity (say, spot silver) and an equal short position in the underlying futures of an appropriate term. Because arbitrage often requires no money, financing is required for the acquisition of a physical item. Furthermore, the cost of storing an asset throughout the arbitrage period is incurred.

Assume that real silver is worth $750 per unit and one-year silver futures are at $825 (a 10% premium). If a trader tries arbitrage without using his own funds, he obtains a $750 loan at a 5% annual interest rate and purchases a unit of silver. He keeps it at a cost of $12.5 per ounce. Over the course of a year, the total cost of holding this investment is $800 ($750+$37.5+$12.5). He shorts one silver futures contract at $825 and expects to profit by $25 per ounce by the end of the year. However, if silver futures prices fall enough by the time the silver futures contract expires, the arbitrage scheme may fail.

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Arbitrage in Different Precious Metals Asset Classes

Trading in precious metals is also possible via precious metals-specific funds and exchange-traded funds (ETFs).Such funds operate on an end-of-day net asset value (NAV) basis (gold-based mutual funds) or on an exchange-based trading basis in real time (e.g. gold ETFs).All of these funds raise cash from investors and offer a certain number of fund units that reflect fractional stakes in the underlying precious metal. The cash raised are utilized to acquire real bullion (or similar investments, such as other bullion funds).

Traders may not find arbitrage possibilities in end-of-day NAV-based funds, but there are plenty of them in real-time traded gold-based ETFs. Arbitrage traders may seek chances in gold ETFs as well as other assets such as actual gold or gold futures.

Precious metals options contracts (similar to gold options) provide another asset class in which to look for arbitrage possibilities. A synthetic call option, for example, which combines a long gold put option with a long gold future, may be arbitraged against a long call gold option. Both items will provide comparable returns. Any difference in put-call parity might result in an arbitrage opportunity.

Time-Bases Arbitrage (Based on Speculation)

Time-based speculative trading targeted at an arbitrage profit is another type of arbitrage (without’simultaneous’buying and selling). Based on technical indications or patterns, traders may establish time-based bets in precious metals instruments and liquidate them after a certain period of time.

The Basics of Precious Metal Arbitrage

The most regularly traded precious metals are gold, platinum, palladium, and silver. Mining corporations, bullion houses, banks, hedge funds, commodity trading advisors (CTAs), proprietary trading businesses, market makers, and individual traders are all market players.

There are several reasons why, where, and how arbitrage opportunities for precious metals trading are produced. They may be the consequence of fluctuations in demand and supply, trading activity, perceived values of various assets connected to the same underlying asset, different trade market regions, or associated variables such as micro- and macroeconomic factors.

  • Supply and demand: Historically, central banks and governments across the world tied their financial reserves to gold. While most countries have abandoned the gold standard, rising inflation or other macroeconomic developments may cause a major increase in demand for gold, which some perceive to be a safer investment than particular equities or currencies. Furthermore, if it is known that a government institution, such as the Reserve Bank of India, would acquire significant amounts of gold, gold prices in the local market will rise. Active traders actively monitor such events and strive to benefit from them.
  • Price transmission timing: The prices of securities from various classes that are connected to the same underlying asset tend to be in sync with one another. For example, a $3 shift in the spot price of actual gold will be reflected in proportionate proportions in the price of gold futures, gold options, gold ETFs, or gold-based products. Participants in these separate marketplaces may take some time to observe a change in the underlying pricing. This time lag, as well as efforts by other market players to benefit on price differences, creates arbitrage possibilities.
  • Time-bound speculations: Many technical traders attempt to day trade precious metals using time-bound technical indicators, which can include identifying and capturing technical trends in order to take long or short positions, waiting for a specified time period, and liquidating the position based on timing, profit targets, or reached stop-loss levels. Such speculative trading operations, which are often supported by computer programs and algorithms, generate demand and supply gaps that surviving market players detect and exploit via arbitrage or other trading positions.
  • Hedging or arbitrage across several markets: A bullion bank may have a long position in the spot market and a short one in the futures market on the same investment. These marketplaces may respond differently if the amount is great enough. Large-quantity long orders in the spot market raise current prices, whereas large-quantity short orders in the futures market lower futures prices. Each market’s participants will perceive and respond to these changes differently depending on the time of price transmission, resulting in price differentials and arbitrage possibilities.
  • Market influence: Commodities markets are open 24 hours a day, seven days a week, with players engaged in various markets. As the day progresses, trade and arbitrage migrate from one geographical market, say, the London bullion markets, to another, say, the US COMEX, which by the end of the day travels to Singapore/Tokyo, which will then have an influence on London, completing the cycle. Trading activity of market players across these numerous marketplaces, with one market driving the next, generate major arbitrage possibilities. The fluctuating currency rate contributes to the arbitrage momentum.
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Helpful Tips

Here are a few more alternatives and standard practices, some of which may be unique to a given market. Scenarios that should be avoided are also described.

  • Commitment of Traders (COT) Report: The Commodity Futures Trading Commission (CFTC) in the United States produces the weekly COT report, which contains the aggregate holdings of US futures market participants. The report is divided into three parts that aggregate positions held by three categories of traders: commercial traders (often hedgers), non-commercial traders (typically huge speculators), and non-reportable traders (usually small speculators).This report is used by traders to make trading choices. One widely held belief is that non-reportable traders (small speculators) are often incorrect whereas non-commercial traders (big speculators) are frequently accurate. As a result, positions are made in opposition to those in the non-reportable portion and in accordance with those in the non-commercial traders’ section. There is also a widespread assumption that the COT report cannot be trusted since large players, such as banks, constantly shift their net exposures from one market to the next.
  • Open-ended ETFs: A few funds (such as GLD) are open-ended and provide enough arbitrage possibilities. Authorized participants in open-end ETFs buy or sell real gold based on the demand or supply of ETF units (buying/redeeming). They may eliminate or produce extra excess ETF units as the market requires. Prices may track a narrow range due to the technique of purchasing/selling actual gold based on the purchase/redemption of ETF units by authorized agents. Furthermore, these actions provide substantial chances for arbitrage between actual gold and ETF units.
  • ETFs that are closed-ended: A few funds are closed-ended (like PHYS).These have a finite amount of units and no way to create additional ones. Such funds allow withdrawals (redemption of existing units) but not inflows (no new unit creation).Due to the limited supply of existing units, great demand often results in swapping existing units for significant premiums. For the same reason, availability on discount is typically not available here. Because the profit possibility is on the seller’s side, these closed-end funds are not appropriate for arbitrage. The buyer must wait and watch for the underlying asset’s organic price rise to surpass the premium paid. However, a trader might charge a premium while selling.
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Not all funds spend their whole cash in the listed asset. The PSLV ETN, for example, invests 99% of its capital in real silver and keeps the remaining 1% in cash. Investing $1,000 in PSLV results in $990 worth of silver and $10 in cash. Given the razor-thin profit margins of arbitrage trading, not to mention transaction expenses, everyone making a trading decision should be well informed about the assets being exchanged.

Knowledge of tradable assets is required before trying arbitrage across several assets. A few funds, for example, (such as Sprott Actual Silver Trust Units [PSLV]) provide the option of conversion to physical metal. Traders should exercise caution and avoid paying a premium for such assets unless they are assured of an intrinsic price appreciation.

Traders may investigate arbitrage chances further by using exchange-traded products. For example, the price to net asset value of various platinum ETFs and ETNs may change (NAV).GraniteShares Platinum Trust (PLTM), Aberdeen Standard Physical Platinum Shares ETF (PPLT), and iPath Series B Bloomberg Platinum Subindex Total Return ETN are all platinum ETFs (PGM).A trader may purchase stocks with a low market price to NAV and sell stocks with a high market price to NAV.

There are also other ETFs and ETNs for gold and silver, as well as a number of non-precious metals.

The Bottom Line

Arbitrage trading is fraught with danger and may be difficult. Atrader will be in an exposed position if the purchase order is executed but the sell order is not. Trading across different securities classes, typically across several exchanges and marketplaces, introduces new operational issues. Profit margins are eroded by transaction expenses, currency rates, and trading subscription charges. Precious metals markets have their own characteristics, and traders should exercise prudence and due research before attempting arbitrage in trading precious metals.

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