How Precious Metals Like Gold Can Be Arbitraged

Precious metals are classified as commodities, and can be traded via multiple security classes such as metal trading (spot trading), futures, options, funds, and exchange 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. As with any other tradable asset, arbitrage opportunities exist in precious metals trading. This article explains the basics of precious metals arbitrage trading, and provides examples of how investors and traders can profit from arbitrage in precious metals trading.

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 (i.e. the 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 one, making a $2 profit.

Many variants of arbitrage exist. For instance:

• 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, let us say that the price of gold in New York is $1250 per ounce, and in London it is GBP 802 per ounce. Assume an exchange rate of 1 USD = 0.65 GBP, which makes the dollar equivalent London gold price $1233.8. 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 $1243.8, and the trader can expect to sell it for $1250, for a profit of $6.2.

One important detail not addressed here is the time to delivery. It may take at least a day for the desired shipment to reach New York from London, by air or by ship. The trader runs the risk of a price decline during this transit period, which – if the price dips below $1243.8 – 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 a cost.

Assume physical silver is trading at $100 per unit, and one-year silver futures are trading at $110 (a 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 a 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 futures prices dip to $104 or less when the silver futures contract expires.

• Arbitrage in Different Precious Metals Asset Classes – Precious metals trading is also available through precious metals-specific funds and ETFs. Such funds either operate on an end-of-day net asset value (NAV) basis (gold-based mutual funds) or on a real-time exchange-based trading basis (e.g. gold ETFs). All such funds collect capital from investors and sell a specified number of fund units representing fractional investments in the underlying precious metal. Capital collected is used to purchase physical bullion (or similar investments, such as other bullion funds). Traders may not get arbitrage opportunities in end-of-day NAV-based funds, but ample arbitrage opportunities are available using real-time traded gold-based ETFs. Arbitrage traders can look for opportunities across gold ETFs and other assets, such as 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 in which 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 for $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 a potential arbitrage profit of $80. Transactional costs that may bring down or diminish profits also need to be considered.

• 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 metals securities and liquidate them after a specified time, based on technical 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 (CTAs), proprietary trading firms, market makers, and individual traders.

There are multiple reasons why, where, and how arbitrage opportunities are created for precious metals trading. They may be a result of demand and supply variations, trading activities, perceived valuations of the different assets linked to the same underlying one, different geographies of the trade markets, or related variables, 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, moving inflation, or related macro-economic changes, can lead to a significant surge in demand for gold, as it is considered by some to be a safer investment than individual stocks or currencies. In addition, if it is known that a government entity, such as the Reserve Bank of India, will purchase large quantities of gold, this will drive 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 asset tend to stay in sync with each other. For example, a $3 change in the price of physical gold in the spot market will sooner or later be reflected in the price of gold futures, gold options, gold ETFs, or gold-based funds in appropriate proportions. 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.

Here are a few other additional options and common practices, some of which may be peculiar 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 ETFs: A few funds are open-ended (like GLD) and offer sufficient arbitrage opportunities. Open-end ETFs have authorized participants who purchase or sell physical gold, depending on the demand or supply of ETF units (buying/redeeming). They are able to reduce or create additional surplus ETF units as needed by the market. The mechanism of purchasing/selling physical gold based on the purchase/redemption of ETF units by authorized agents allows prices to stalk a tight range. Additionally, these activities offer significant opportunities for arbitrage between physical gold and ETF units.

Arbitrage trading involves a high level of risk, and can get 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. Transaction costs, forex rates, and the subscription costs of trading erode profit margins. Precious metals markets have their own dynamics, and traders should practice due diligence and caution before trying arbitrage in trading precious metals.