The Arbitrage Potential of Precious Metals

Using derivatives markets to speculate on or hedge against price fluctuations of commodities such as gold and silver.

FREMONT, CA: Precious metals are commodities and can be traded through numerous securities classes, including spot trading, futures, options, mutual funds, and exchange-traded funds (ETFs). Gold and silver, two of the most widely traded and popular commodities for investing, offer abundant trading opportunities with high liquidity on a global scale.

As with any other asset class, arbitrage opportunities abound in the trade of precious metals. This article describes the fundamentals of arbitrage trading in precious metals and includes how investors and traders can profit from arbitrage in precious metals trading.

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

Also accessible for trading precious metals are precious metals-specific funds and exchange-traded funds (ETFs). These funds either operate on a net asset value (NAV) basis at the end of the trading day (gold-based mutual funds) or on a real-time exchange-based trading basis (e.g., gold ETFs). These funds collect capital from investors and sell a certain number of fund units that reflect fractional interests in the precious metal underpinning the fund. The accumulated cash is utilized to acquire actual bullion (or similar investments, such as other bullion funds).

Traders may not have arbitrage possibilities with end-of-day NAV-based funds, while arbitrage opportunities are abundant with gold-based ETFs traded in real-time. Arbitrageurs can look for options between gold ETFs and other assets, such as actual gold or gold futures, while seeking arbitrage opportunities.

Precious metals options contracts (such as gold options) provide an additional asset class for arbitrage opportunities. For instance, a synthetic call option consisting of a long gold put option and a long gold future can be arbitraged against a long call gold option. Both goods will provide comparable returns. Any disparity in put-call parity may present an arbitrage opportunity.

Gold, platinum, palladium, and silver are most often traded precious metals. Participants in the market consist of mining companies, bullion houses, banks, hedge funds, commodity trading advisors (CTAs), proprietary trading firms, market makers, and individual traders.

Arbitrage chances are produced for trading precious metals for various motives, locations, and methods. They may be the result of demand and supply changes, trading activity, perceived valuations of the several assets linked to the same underlying one, varying locations of the trade marketplaces, or other variables, such as micro-and macroeconomic issues.

Supply and demand: Historically, governments and central banks across the globe tied their financial reserves to gold. Although most governments have abandoned the gold standard, fluctuating inflation or related macroeconomic events can lead to a considerable increase in demand for gold, as some view it as a safer investment than equities or currencies. Moreover, if it is known that a government institution, such as the Reserve Bank of India, will purchase large quantities of gold, gold prices on the local market will increase. Active traders closely monitor these developments and seek to profit from them.

Timing of price transmission: the prices of securities from different classes connected to the same underlying asset tend to move in tandem. For instance, a $3 shift in the spot market price of actual gold will sooner or later be reflected in the prices of gold futures, gold options, gold ETFs, and gold-based vehicles. It may take time for participants in these various markets to detect a change in the underlying's price. This lag in time and the efforts of different market participants to benefit from the price differences generate arbitrage opportunities.