Cash vs Futures – The difference between cash metals and futures contract fundamentals

A futures contract is an agreement to buy or sell a specified amount of a commodity at a predefined price and date. The COMEX aluminum futures contract for example is equal to 44,000 pounds or approximately $27,000 of aluminum and can be delivered in the four consecutive months starting with the current month. This does not mean you have to have $27,000 to trade one contract. Futures contracts are leveraged products. This simply means that you only have to put up a portion of the contract’s full value. The capital requirement to trade a futures contract is called the margin. For aluminum, non-member speculative initial margin is $3,038; a little over 10% of the contracts full value. Leverage is an interesting tool that can be very beneficial when used properly, but it must be approached with caution. Leverage essentially increases both your possible potential for profits and – more importantly – possible potential for losses. When trading futures you can actually lose more money than your initial investment.
The cash metals markets are another story. Other common names for a cash market are spot or physical markets. These three names come from a transaction where "cash" is given for a "physical" commodity with the exchange occurring on the "spot." Due to the costs of storing and transporting a physical commodity, cash metals transactions are usually undertaken by commercial interests, while speculators tend to gravitate towards futures.
Another major discrepancy between the cash metals markets and futures markets is the contract size specifications - or lack thereof. This is an interesting notion. Let’s use gold for example. A CME gold futures contract is equal to 100 troy ounces or approximately $100,000 at current market value. If you want to take delivery of the gold you’re forced not only to pay for transportation costs, but you also have to take delivery on the whole contract. There are few people in the world who can afford to purchase 100 ounces of gold. On the other hand, you can go to one of your local bullion dealers and buy an ounce or two of gold on the cash metals market and walk home with a shiny new gold Krugerrand. The lack of a minimum purchase in the cash market can cause divergence between spot and futures prices, and that’s exactly what we saw in 2008. Gold prices collapsed from $1000/oz to sub $700/oz. While futures prices continued to head lower, the spot market began a recovery. Bullion dealers around the world were reporting shortages due to large quantities of demand. The reason for this divergence is the above mentioned reasons. The majority of individual investors use the spot market to procure their physical metals.
The different aspects of metals futures and cash metals markets are important to understand if you’re going to be trading metals. While the cash metals market is strong, it would be frustrating to be long gold futures in a declining futures market.

Disclaimer: Trading in futures and options involves a substantial degree of a risk of loss and is not suitable for all investors. Past performance is not indicative of future results.