Dealers, Brokers and Traders
In the world’s free markets, precious metals trading is in the hands of dealers and brokers. The difference between a dealer and a broker is determined by their function. A broker merely acts as an intermediary between a regulated exchange and an investor. To cover his overhead, he charges a commission, but at no time during the transaction does the broker actually own precious metals. A dealer, on the other hand, will purchase or sell a precious metal on his own account in order to make a trading profit. Thus, dealers always have a position in the market, either short or long.
Dealers usually do not charge a commission for the transactions you conduct through them. Instead, they make their money on the “spread”, the difference between the price at which they purchase gold and what they can sell it for. Because a dealer lives off his spread, he has to constantly anticipate market movements. If he expects gold to rise, he tries to increase the amount of gold he has and bids a higher price for it than he would ordinarily. Alternatively, if he thinks the market is set for a decline, he may lower his selling price in order to get rid of the position he is sitting on as quickly as possible. Precious metals dealers are usually connected with the banking, investment and refining industries. In North America, the banks and refiners operate primarily in bullion, certificates and coinage, while the investment dealers concentrate on mining shares, futures contracts and options.
A dealing firm’s day-to-day business is handled by traders, full time professionals whose job is to identify and exploit market opportunities. In constant search for new information and new markets, these traders are in touch with other dealers all over the world. Quite often, they have full discretion over very sizeable positions. Thus, the dealing community can have an influence on the market all its own, although the basic laws of supply and demand always reassert themselves eventually.
Most bullion dealers derive a substantial portion of their profits from transactions with the public. But an increasing amount of money is also being made from more complicated trading operations, such as “arbitrages”. Originally used to describe the simultaneous purchase and sale of a metal through two different dealers or in two different markets, the term “arbitrage” now refers to a wide variety of maneuvers. Dealing in a number of different markets allows a trader to spot the chance of purchasing gold at a lower price in one place than he can sell it for elsewhere. For example, the London market may react downward slightly when a very large gold holding is liquidated there. At the same time, someone else may be purchasing a significant amount of gold in New York. The price difference is usually very small and therefore dealers have to trade in considerable quantities in order to make the transaction worth their while.
More difficult arbitrage operations are those which involve the cost of lending or borrowing money. A trader might notice, for example, that gold for cash delivery is selling at $400. At the same time, bullion for three months delivery is trading at $411. The difference of 2.75% is now compared to current interest rates. At a lending rate of ten percent, the trader can effectively borrow three months working capital at a quarterly rate of 2.5 percent. Consequently, there is room for profit. The trader will therefore borrow as much money as he can at the cost of 2.5 percent. At exactly the same time, he purchases gold in the cash market for the amount he has borrowed and simultaneously sells it three months out. His net profit from this transaction will only be 0.25 percent, but on a large volume that is a sizeable yield. If the trader works for a bank, where the cost of borrowing is considerably lower, the profit is even greater.
But suppose ten traders of large banks exploited the same opportunity. As a result of the increase in demand, the price of cash gold would immediately go up, while the price of gold for three months delivery would come down, reflecting the increased supply. If the three months gold price dipped substantially below the cost of money, the opposite arbitrage possibility would exist. The dealers would sell bullion into the cash market and simultaneously buy it back for three months delivery. The money realized from the cash sale could then be invested in a money market instrument yielding a higher percentage than the transaction cost.
Trading rooms take getting used to. Even a small dealing operation is a place where emotions run high and voice levels rise. Precious metals are a barometer of political and economic well being, which forces traders to constantly monitor monetary and political events throughout the world. A terrorist raid by African guerillas into Zaire, the latest harvest results from Russia or the release of last month’s Krugerrand sales figures are all equally important to the modern gold trader. A North American trading operation begins transacting business with European dealers early in the morning and stays open late into the evening in order to buy and sell precious metals in Hong Kong. But the explosion in communications facilities will probably lead to even further expansion in the future. Some bullion dealers are now toying with the idea of establishing 24-hour trading operations in order to take advantage of all the market shifts and arbitrage opportunities which occur around the world in the span of a day.
Bullion Trading Centers
Most people readily identify the London market as the world’s centre for precious metals. Ever since 1666, when King Charles II gave London bullion merchants control over gold and silver dealings, English trading activity has been centered there. Later, when the Empire’s large gold discoveries in Australia and South Africa were made, London advanced to the rank of being the world’s most important market.
Today, London gold bullion trading is organized by five participants. Mocatta and Goldsmith Ltd., the oldest house, was founded ten years before even the Bank of England opened its doors. The other firms are Samuel Montagu & Co., Sharps Pixley & Co. Ltd., N.M. Rothschild & Sons and Johnson Matthey Bankers Ltd. As they did 150 years ago, so they still meet twice a day for the famous London Gold Fixing sessions. Their representatives get together in a room at N.M. Rothschild’s where each has a table with a telephone and a small Union Jack flag. On arrival, each representative determines the amount of gold his institution would ideally like to buy or sell at various prices. When the fixing session gets underway, the chairman calls out a figure and the representatives respond by pointing their flags down or raising them upright, thus indicating whether they would buy or sell at the suggested price. If all attendants wish to sell, the chairman lowers his figure until some show interest in buying. If, at the beginning, they all want to buy, the chairman raises the figure. Once the flags show that there are buyers and sellers among the five, all attendants reveal how much they would like to transact. If the totals are not in agreement, the chairman, traditionally the representative of N.M. Rothschild, makes a proposal to bring the sums into line.
Throughout this session, all five gentlemen are in telephone contact with their institutions’ dealing rooms. When the fixing figure is final, it is transmitted throughout the world by every conceivable means, Although only the London five are bound by them, these fixings still serve as an accurate reflection of supply and demand in the world market and are therefore an important indicator to dealers everywhere.
The London gold market functions in accordance with several set trading guidelines. Their dealers specify what bars are acceptable, what fineness they need to have, and where delivery can be made. Most leading gold dealers in North America maintain a “bullion account” with one or more of the five London dealers through which they can settle transactions between themselves. It is quite conceivable that a Far East gold trader and a bank in Canada would agree on London delivery when trading gold with each other.
Still, the London market has declined considerably in importance. In the early Seventies, South Africa shifted a major portion of its gold sales to Zurich, where a newly established “pool” combined the resources of Credit Suisse, Swiss Bank Corporation and Union Bank of Switzerland. Shortly thereafter, when the Soviets brought sizeable amounts of gold to the market, they started to use their own bank which they had established in Zurich to look after the major portion of their sales. Thus, Zurich and London are today of equal importance and, as far as the physical bullion market is concerned, are still the world leaders. Other centers, such as Frankfurt, Luxembourg, Hong Kong, New York, Singapore or Toronto are sizeable enough to provide sufficient liquidity for investors, but rarely affect price trends. Bullion dealers in London, Zurich and these secondary markets, by the way, don’t deal in gold alone. In most cases, they are equally active in the silver, platinum and palladium markets.
The Exchange Centers
In 1974, the ban on private gold ownership was lifted in the United States. Banks and dealers opened up trading operations similar to those in London and Zurich, and in time they prospered. But of far more importance was the fact that precious metals could now also be traded on the commodities exchanges. The Chicago Board of Trade and the New York Commodity Exchange correctly anticipated that they could convince investors that buying precious metals with cash was outmoded, and that leverage was the way to go. Within a few years, futures trading changed the structure of international bullion markets forever.
On New York’s COMEX, for example, trading in gold bullion soared to over eight million contracts during 1980. This was equivalent to 24,883 metric tons — almost twenty times the annual world production of gold! European bullion dealers found it hard to believe that American views on investing were so different than the trends back home. But, for their own purposes, they too found the futures market to be a very convenient vehicle, if they wished to protect a position overnight, they could simply buy or sell contracts in Chicago or New York and liquidate them again the next day. This possibility was extended even further when Far Eastern markets in Hong Kong and Singapore provided the same facility. North American dealers could now protect their open positions and then offset them in Europe a few hours later. Thus, the leading old world bullion dealers contributed significant volume to the new “paper markets”, and precious metals markets literally became a 24-hour affair.
Today, futures markets are even more important. By far the most liquid marketplace, they now serve dealers, producers and industrial users alike. New York’s COM EX has become the largest trading centre for gold and silver futures, while the New York Mercantile Exchange dominates platinum and palladium trading. A second tier of exchanges offering precious metals futures include Chicago, London and Hong Kong, among others.
Most observers agree that the world’s stock and commodities exchanges will increasingly focus in on precious metals. After all, they are already set up to provide an exchange mechanism, and vehicles such as futures contracts or options have been offered by them for many years. Some experts also fear that this will spell the end of the bullion dealing industry, but they totally forget that investors will always be interested in buying physical bullion as long term insurance. The only significant change will be that both the brokerage community and the bullion dealers will learn from each other, with the result that their knowledge and their servicing ability will improve. We, as investors, can only benefit from this trend.
PLAYING THE RATIOS
Most investors think of their gold, silver or other precious metals in terms of U.S. dollars per ounce. But very few people actually keep track of what the price relationship is between these individual metals over a period of time. Playing the ratios can be a highly rewarding game, particularly for those of you who view precious metals as trading vehicles, not just as insurance. Try to make a habit of asking yourself whether gold is fairly priced in terms of silver, or how many ounces of palladium it takes to purchase an ounce of gold. At best, doing so will alert you to trading opportunities and, at worst, it will make you very aware of the basic economic trends affecting precious metals.
Let’s begin by studying the price relationships between precious metals in early 1980, and comparing them to those in mid-1982. As you know, these two time frames are both extremes: the former was a period of record prices while the latter was a period when demand was practically zero. The table opposite illustrates how sharply the nominal prices of precious metals fell, but it is even more interesting to see what happened to the ratios. In early 1980, you could only get fifteen ounces of silver for one ounce of gold, whereas in June of 1982 you could get 58! What this shows us is that the already volatile fluctuations in metals prices are magnified even further in the movement of the ratios. The primary reason for this is that gold’s relative fluctuations during the economic cycle are smaller than those of the more industrially used precious metals, such as silver, platinum and palladium. As you can see, this translated into a situation where, at the height of the recent recession, the purchasing power of gold had increased vis-a-vis silver more than three times. The same holds true for platinum and palladium. One ounce of gold bought 0.8 ounces of platinum at the top of the cycle, but in June of 1982 could have purchased more than 1.2 ounces. The same ounce of the yellow metal could purchase only 1.7 ounces of palladium in early 1980, but could later have been traded in for more than seven ounces!
Thus, of all the precious metals, it was again palladium which had the greatest upside potential.
If these were the extremes, are there any norms to which one can expect the precious metals ratio to return under normal conditions? The history of recent years certainly suggests that there are. In a properly operating economy, the ratios should be approximately as follows:
- ounce of gold should be equivalent to 35 ounces of silver.
- ounce of gold should be equivalent t 0.66 ounces of platinum.
-ounce of gold should be equivalent to about 2.5 ounces of palladium.
What will be required to create a return to these ideal ratios is a sustained economic recovery. Along with gold, the more industrially based precious metals will anticipate higher inflation and appreciate. In addition, they will also be affected by stronger industrial demand, far more so than gold. The rate of gain for all these metals, therefore, will be higher than that for the yellow metal.
If you wanted to exploit this opportunity, you could utilize two different strategies. The first one is by far the more daring because it involves the futures markets, margin deposits and, if the market goes against you, additional margin calls from your broker. However, futures markets also give you far more leverage and allow you to play this game on a larger scale.
As a ratio trader, you could short a certain number of contracts of gold and go long roughly the same dollar equivalent in silver or palladium contracts. (If this is confusing to you, see the section on futures contracts.) Because the timing of such ratio changes is very difficult to predict, you would want to purchase contracts with a delivery date quite far in the future. Your broker, incidentally, would not understand the term ratio trading, but would refer to this transaction as “spreading between two related commodities”.
The second, far less risky, strategy you could pursue is that of simply switching from gold into some other precious metal and back into gold. For instance, let’s assume you purchased $1,000 worth of silver in January 1974. Let’s further assume that each time the gold/silver ratio moved to below 30 you converted your hunk of silver into gold bullion. Alternatively, each time the ratio moved to around 40:1 you exchanged your gold back into silver bullion. If you had followed through and acted on each one of these ratio changes, you would now be sitting on roughly 1.250 ounces of silver worth more than ten times as much as your initial investment!
How would that compare to a straight purchase of either gold or silver over the same period of time? Had you invested your $1,000 in either one of the two metals, you would now have about three times as much. In other words, trading the ratios would have boosted your investment performance by more than three times. In the futures markets, this same result would of course be magnified many times over.
I have used the example of gold and silver to make this illustration, but the situation is exactly the same with platinum and palladium. By now, I have probably convinced you that ratio trading is a dead sure game and that by playing one precious metal against another, the risk of exposure is cut down considerably. However, I want to make it perfectly clear that ratios are based on patterns of the past and history does not always repeal itself. In my opinion, there is a good chance that we will revert to what I call the ideal ratios at some time in the future, but the wait could be a long one.
FUNDAMENTALS AND CHARTS
In the sections dealing with gold, silver and platinum group metals we discussed a great variety of factors powerful enough to influence the price of gold, all of which have one thing in common: they are fundamental. To be more explicit, they are guaranteed to have an effect on demand and supply, and thus on the price. Assessing all these aspects is an immense task and requires a highly developed understanding of the precious metals market.
Until a few years ago, the bullion dealing community insisted that such economic analysis was the only effort worth while. But in the last ten years things have changed considerably. With the advent of the futures markets, bullion trading became a game with a far shorter time span. Thousands of contracts are initiated every day, with the sole purpose of liquidation later in the week. The sheer volume of such speculative trading can create short term trends of their own, often overriding the longer term supply and demand fundamentals. Technical chartists have developed methods to read such trends accurately and have thus given their trade a far higher standing. Today, no professional can afford not to look at both the fundamental and the technical side, because they are equally important. The study of fundamentals gives him a good understanding of the longer term trend, while technical analysis provides important clues as to the exact timing of each move.
Obviously, fundamental and technical analysts often have differing views. But fortunately they have also learned a lot from each other and their long-lasting feud has given way to mutual respect.
Getting used to making your own charts will not only teach you how markets behave but will also force you to stay in touch with your investments on a day to day basis. Some brokerage houses give courses on chart making and several newsletters specialize in technical analysis. Of these, I can recommend Deliberations and Aden Analysis. The addresses for both these publications can be found in our section on newsletters.