The Best Way to Hedge Precious Metals
If precious metals are a vital component of your business’s raison d’etre, you likely want to limit exposure to the wild price swings in the market. Sure, there are many ways in which a company can minimize risk, but in current markets, the real question is – Which method works best for you? If you are just now considering hedging, this article will take you through an example of one of the most efficient ways to mitigate risk.
First, let’s define what a hedge is. It is the act of protecting oneself against loss on investment by making balancing or compensating transactions. What does this mean in practice? Well, let’s look at an example.
Example: Precious Metals Mining Hedging
Our hypothetical Company mines Gold – let’s call them Goldmineco. For a given year, they know roughly what their operational costs entail. Now, let’s assume that the price of gold rises significantly within a short period of time. Goldmineco sees this high price and wants to get that price for all the gold they will mine that year. Their want to capitalize on the high price defines their problem as the year is not over, and they still have gold in the ground that can’t be delivered to their buyer. Goldmineco decides to lock in its entire annual production at the inflated price via hedging. Instead of waiting for the physical gold to be ready to deliver, Goldmineco will go to the futures market.
The futures market deals in versatile financial agreements that buy or sell commodities of a set amount and specific quality at a set point in time – that time is known as the maturation date. As an aside – An opposite trade offsets approximately 98% of futures contracts before they reach their maturation date. Futures contracts are straightforward to use and, as the initial margin is usually somewhere between 2-5% of the contract’s total value, provide a high degree of leverage.
To lock in the desired price, Goldmineco sells futures contracts equal to their annual production. If they mine 100 kilos of gold a year, they sell a futures contract for 100 kilos. Then, once the company achieves its production level, several things happen:
- Goldmineco sells the physical gold to buyers and simultaneously buys back the same number of futures contracts they initially sold. As they are both buying and selling the same amount, Goldmineco effectively maintains its position.
- The difference in price between the initial sale of futures and the later repurchase of another contract depends upon the price changes in the futures market.
- The difference in price between the sale of the physical gold and the purchase of the offsetting futures contract depends on the prices in the physical market and futures markets, and often results in a small loss.
The Best Way to Hedge Precious Metals
- If the market price falls after the initial futures sale, the company will lose when they sell in the physical market. However, they will make a corresponding profit when they buy the futures.
- The opposite happens if the market price rises. Money is made selling physical gold, but a corresponding amount is lost buying the futures.
- Removing the hedge at the same time as the goods are sold means the company knows its profit for the year, regardless of market fluctuation.
The use of futures provides a simple way to gain market exposure without worrying about emotional and speculative decisions related to price action (or market movement). The simplicity of these instruments and the liquidity of global markets allow these contracts to be entered and exited with great ease. Hedging reduces the risk of maintaining extensive inventories whose values may fluctuate significantly over time. Warehouse costs are not an added expenditure, nor are shipping costs a constant burden.
Futures contracts can be used for most precious metals, including gold, silver, platinum and palladium.
Small businesses can reap the benefits of using futures contracts to reduce their potential for loss from the vagaries of the marketplace.