Posted by: American Hard Assets in Diversified Investments 2 hours ago

Feb 18 (Investopedia) —  Precious metals are considered commodities and can be traded through multiple security classes such as metal trading (spot trading), futures, options, funds, andexchange traded funds (ETF). Across the globe, two of the most heavily traded and most popular commodities for investments—gold and silver—offer ample trading opportunities with high liquidity. Like any other tradable asset, arbitrage opportunities exist in precious metals trading. This article explains the basics of precious metals arbitrage trading and examples of how investors and traders can profit from arbitrage in precious metals trading.

What is Arbitrage?

Arbitrage involves the simultaneous buying and selling of a security (or its different variants like equity or futures) to benefit from the price differential between the buy and sell price (or bid and ask spread). For example, the price of gold at Comex is $ 1225. On a local exchange, bullion is sold at $ 1227. One can buy at the lower price and sell it at the higher, making a $ 2 profit.

Many variants exist for arbitrage:

• Market Location Arbitrage  – The difference in demand and supply of a precious metal in one geographical market (location) compared to that in another market could lead to a difference in price, which arbitrageurs attempt to capitalize upon. This is the simplest and most popular form of arbitrage. For example, say the price of gold in New York is $ 1250 per ounce and in London it is GBP 802 per ounce.  Assume exchange rate of 1 USD = 0.65 GBP which makes the dollar equivalent London gold price $ 1235.5. Assume the cost of shipping from London to New York is $ 10. A trader can expect to benefit by purchasing gold in the lower cost market (London) and selling it in the higher priced market (New York). Total buy price (cost plus shipping) will be $ 1245.5 and trader can expect to sell it for $ 1250, for a profit of $ 4.5.

One important part that is getting missed here is the time to delivery. It may take at least a day for the desired shipment to reach New York from London (say by air) or longer (by ship). The trader runs the risk of a price decline during this transit period, which if dips below $ 1245.5 will lead to a loss.

• Cash and Carry Arbitrage — This involves creating a portfolio of long positions in the physical asset (say spot silver) and an equivalent short position in the underlying futures of a suitable duration. Since arbitrage usually involves no capital, financing is needed for a physical asset purchase. Additionally, storage of an asset during the arbitrage duration also incurs cost.

Assume physical silver is trading at $ 100 per unit and one-year silver futures are trading at $ 110 (10% premium). If a trader attempts arbitrage without using his own money, he takes a loan of $ 100 with a 2% annual interest rate and buys a unit of silver. He stores it at storage cost of $ 2. The total cost of carrying this position over the year is $ 104 ($ 100+$ 2+$ 2). For arbitrage, he shorts one silver future at $ 110 and expects to benefit by $ 6 at the end of the year. However, the arbitrage strategy will fail if the silver future prices dip to $ 104 or less at the time of expiry of the silver futures contract.

• Arbitrage in Different Precious Metal Asset Classes – Precious metal trading is also available through precious metal-specific funds and ETF. Such funds either operate on an end-of-the-day net asset value (NAV) basis (gold-based mutual funds) or on real-time exchange-based trading basis (e.g. gold ETF). All such funds collect capital from investors and sell a specified number of fund units that represent fractional investments in the underlying precious metal. Capital collected is used to purchase physical bullion (or similar investments like other bullion funds). Traders may not get arbitrage opportunities in end-of-the-day NAV-based funds, but ample arbitrage opportunities are available using real-time traded gold-based ETF. Arbitrage traders can look for opportunities across gold ETF and other assets like physical gold or gold futures. (See related: Which Gold ETF you should own and The 5 best performing gold ETFs.)

Precious metals options contracts (like gold options) offer another security class to explore arbitrage opportunities. For example, a synthetic call option, which is a combination of a long gold put option and a long gold future, can be arbitraged against a long call gold option. Both products will have similar payoffs. As of February 2015, one-year-long gold put options with a strike price of $ 1210 were available for $ 1,720 (lot size 100), call options for $ 2,810, and futures $ 1210. Barring transactional costs, the first position (put + future) can be created for ($ 1,210 + $ 1,720 = $ 2,930) and against the call price of $ 2,810, offering arbitrage potential profit of $ 80. Transactional costs also need to be considered that may bring down or diminish the profits.

• Time Arbitrage (Based on Speculation)— Another variant of arbitrage (sans “simultaneous” buying and selling) is time-based speculative trading aimed at an arbitrage profit. Traders may take time-based positions in precious metal securities and liquidate them after a specified time, based ontechnical indicators or patterns.

Gold, platinum, palladium, and silver are the most commonly traded precious metals. Market participants include mining companies, bullion houses, banks, hedge funds, commodity trading advisors (CTA), proprietary trading firms, market makers, and individual traders.

There are multiple reasons why, where, and how arbitrage opportunities get created for precious metal trading. They may be a result of demand and supply variations, trading activities, perceived valuations of the different assets linked to the same underlying, different geographies of the trade markets, or related factors, including micro- and macro-economic factors.

• Supply and Demand: Central banks and governments across the globe used to tie their cash reserves to gold. While the gold standard has been abandoned by most nations, a change in inflation or related macro-economic changes can lead to a significant surge in demand for gold as it is considered by some to a safer investment than individual stocks or currencies. In addition, if it is known that the government entity, such as the Reserve Bank of India, will purchase big quantities of gold, this will drives up gold prices in the local market. Active traders closely follow such developments and attempt to take profits.
• Price Transmission Timing: The prices of securities belonging to different classes but linked to the same underlying tend to stay in sync with each other. For example, a $ 3 change in the price of physical gold in spot market will sooner or later get reflected in the price of gold futures, gold options, gold ETF, or gold-based funds in appropriate proportions. However, the market participants in these individual markets may take time to notice the change in the prices of the underlying. This time lag and attempts by different market participants to capitalize on the price gaps create arbitrage opportunities.
• Time Bound Speculations: Many technical traders attempt to day trade precious metals on time-bound technical indicators that can involve 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 achieved stop-loss levels. Such speculative trading activities, often aided by computer programs and algorithms, create demand and supply gaps sensed by remaining market participants who therefore attempt to benefit from arbitrage or other trading positions.
• Hedging or Arbitrage Across Multiple Markets: A bullion bank may take a long position in the spot market and short the same investment in the futures market. If the quantity is large enough, both markets may react differently. The large quantity long order in the spot market will push spot prices up, while the large quantity short order will push the futures prices down in futures market. Participants of each market will perceive and react to these changes differently based on the timing of the price transmission, leading to price differentials and arbitrage opportunities.
• Market Influence: Commodities markets run 24/7 with participants active across multiple markets. As the day passes, trading and arbitrage flow from one geographical market, say the London bullion markets, to another, like US COMEX, which by its closing time moves to Singapore/Tokyo, which will later have an impact on London, thereby completing the cycle. The trading activities of market participants across these multiple markets with one market driving the other create significant opportunities for arbitrage. And the continuously changing exchange rate adds to the arbitrage momentum.

Helpful Tips

Here are few other additional options and common practices, some of which may be specific to a particular market. Also covered are scenarios that  should be avoided.

• Commitment of Traders Report (COT): In the US, the Commodity Futures Trading Commission (CFTC) publishes the weekly COT report with the aggregate holdings of US futures market participants. The report contains three sections for aggregate positions held by three different types of traders: “commercial traders” (usually hedgers), “non-commercial traders” (usually large speculators), and “non-reportable” (usually small speculators). Traders use this report to make trading decisions. One common perception is that non-reportable traders (small speculators) are usually wrong and non-commercial traders (large speculators) are usually correct. Hence, positions are taken against those in the non-reportable section and in line with those in the non-commercial traders section. There is also a common belief that the COT report cannot be relied upon, as major participants like banks keep moving their net exposures from one market to the other.
• Open-end ETF: A few funds are open-ended (like GLD) and offer sufficient arbitrage opportunities. Open-ended ETFs have authorized participants who purchase or sell physical gold depending upon the demand or supply of ETF units (buying/redeeming). They are able to reduce or create additional surplus ETF units as the market needs. The mechanism of purchasing/selling physical gold based on the purchase/redemption of ETF units by authorized agents allows prices to remain in a tight range. Additionally these activities offer significant opportunities for arbitrage between physical gold and ETF units.
• Closed-end ETF: Few funds are closed-end (like PHYS). These have limited number of units without any possibility of creating new ones. Such funds are open to outflows (redemption of existing units), but are closed to inflows (no new unit creation). Due to availability restricted to existing units only, a high demand often results in trading the existing units for high premiums. Availability on discount is usually not applicable here for the same reason. These closed-end funds would not be good for arbitrage, as the profit potential is limited to the seller. The buyer has to wait and watch for the organic price growth of the underlying asset that should exceed the premium paid. However, a trader can command the premium at the time of selling.
• Knowledge about the tradable assets is an important requirement before attempting to arbitrage across multiple assets. For example, a few funds (like Sprott Phys Slv Trust Units [PSLV]) come with the option to convert to physical bullion. Traders should be cautious and avoid purchasing such assets at a premium, unless they are certain about an intrinsic price appreciation.
• Not all funds invest 100% of the invested money into the mentioned asset. For instance, PSLV invests 99% capital in physical silver and maintains remaining 1% in cash. Investing $ 1000 in PSLV gets you $ 990 worth of silver and $ 10 in cash. With wafer-thin profit margins available in arbitrage trading and transaction costs, traders should be fully aware of the assets before making a trading decision.
• Traders can further explore arbitrage opportunities in higher magnitudes of exposures through ETF’s. For instance, following two platinum-based ETF’s offer twice the exposure for leveraged long and short positions linked to the S&P GSCI Platinum Index – VelocityShares 2x Long Platinum ETN and VelocityShares 2x Inverse Platinum ETN. Similarly, for triple exposure to S&P GSCI Silver index, one can explore VelocityShares 3x Long Silver ETN (USLV) and VelocityShares 3x Inverse Silver (DLSV). These funds, and similar combinations, can also be arbitraged against other securities on the same underlying precious metal.

The Bottom Line

Arbitrage trading involves a high level of risk and at times gets challenging. If the buy order gets executed and the sell order does not, a trader will be sitting on an exposed position. Trading across multiple security classes, often across multiple exchanges and markets, brings its own set of operational challenges. Transactional costs, forex rates, and subscription costs for trading may further reduce the profit margins. Precious metal markets have their own dynamics, and traders should practice due diligence and caution before trying arbitrage in trading precious metals.

SOURCE

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