by Keith Weiner, Sprott Money:

When someone asks what the price of gold is, the answer depends on which gold market he means.

In most cases, the different gold markets are close enough that the minor differences are insignificant. TV news anchors just want to know if the price is in a major trend, up or down (up). Old Uncle Ernie could be reminiscing about the bull market of the 1970s and comparing the price back then to the price today (spoiler: it’s higher today).

The Three Gold Markets

But if you’re studying gold, you may be curious about the differences between the three markets:

• Spot (also known as loco London)*


• COMEX futures


• Retail (i.e., physical coins and bars)

It must be emphasized that these are three different markets. That is, there are different buyers and sellers. Hence there are different balances of supply and demand. And the price in one market is not the same as in the other two.

The prices in these markets are usually very close to one another, but they’re not the same.

If the prices in two different markets are normally very close, then there must be some force that ties them together. It does not happen by accident, and no one maintains it out of charity.

This distance, price A minus price B, is called the “spread.” The wider the spread, the more money that a trader can make, bringing the prices closer together again. This means he would prefer to wait for the spread to widen. However, he has competitors.

Your local gas station might like to charge you $20/gallon for gasoline, but its competitors are happy to undercut that price. So, the gas station would lower its price, and its competitors would lower their price. Eventually, they would stop, and a price truce would be worked out (for a while). The truce occurs when the marginal gas station won’t go any lower.

Enter The Arbitragers

The same thing happens with these special traders in the gold markets, who are called “arbitragers.” They will keep narrowing the spread between spot and futures, until the profit on the trade shrinks to the point where one after the other of them cry uncle and stop going lower.

The key to arbitrage is that it must be possible to convert what one buys in one market into what one sells in another market.

For example, if you buy a 400-ounce gold bar in the London spot market, you could ship it to a refiner to be cast into four 100-ounce bars, which you could then ship to New York to sell. Or you could buy a COMEX future, take delivery of the 100-ounce bar, and send that to a refiner to mint into one-ounce bars to sell to a retailer. Gold is fungible, so these conversions are not only possible, but they are usually fairly inexpensive.

(Note: certain gold mutual funds do not allow conversion. For example, PHYS (traded on the NYSE) currently trades at a 1.4 percent discount to the value of the gold held in its trust. A spread this fat indicates that there is no way for arbitragers to buy shares, take out the gold, and sell it. At 1.4 percent, this would mean buying shares for, say, $1,972 and selling the gold stripped from those shares for $2,000. If this trade were possible, you can be sure someone would be doing it all day long [until the price of PHYS was much closer to the spot price].)

Normally, the price of a futures contract is a bit higher than the price of spot. This is because in buying the futures contract, you are paying someone to warehouse the gold until you need it. There is a cost to finance and store the gold, thus the price is elevated a bit (not a lot).

The price of a futures contract could be driven up significantly. Suppose Federal Reserve Chairman Jay Powell goes on TV to say that he plans to print trillions of dollars in a deliberate attempt to cause inflation. This could never happen, and this is a totally unrealistic example. But just bear with me.

How might markets react to this mad plan? Traders might buy gold. They would not likely be driving to the local coin shop on Main Street. They would be hitting the Buy button on the screen, and for most of them that is connected to the futures market.

Leveraging Futures

In addition to being a lot more accessible to traders than the London market, futures offer another feature. Big leverage. Like 20:1.

A bet of $10,230 can command about $200,000 worth of gold. If the gold price moves up 1 percent, to $2,020, a gold futures contract goes up in value by $20 x 100oz = $2,000. So his $10,230 goes up to $12,230, or about 20 percent. Pretty nifty.

To return to our example, the price of the COMEX futures contract would obviously be pushed up by all this buying. And that creates an opportunity for the arbitragers. They can buy spot gold in London and sell gold futures. They will keep doing that, until the spread narrows to a point.

It’s possible that the price of a gold futures contract could fall below the price of spot gold. This is called “backwardation” (the opposite of the normal condition, called “contango”). The arbitragers can right this capsized boat by selling gold metal and buying gold futures. However, they may not choose to do this even if the profit grows fat. Gold backwardation is a very dangerous condition.

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