How The Gold Market Works

Exploring the intricacies of how the gold market works would take volumes. This primer covers the basic operation of the market and the primary indicators of activity – essential information for making informed investments.

Over-the-Counter

The gold market has two distinct segments. Almost all trading of physical gold takes place on the over-the-counter market (OTC), centered primarily in London, New York, and Zurich. OTC trades are direct unstructured transactions between principals – mining companies, central banks, and industrial consumers. The standard size of OTC gold trades ranges from 5,000 to 10,000 ounces. Investors and speculators can also trade in OTC derivatives similar to those discussed below.

Because physical assets are bought and sold, the current OTC gold market price is an important benchmark. The London fix - the most widely used indicator - is calculated twice daily (the AM fix and the PM fix).

And Into the Futures

What most people think of as the gold market is actually the gold futures market, the trade that takes place on exchanges such as the Commodity Exchange (COMEX) division of the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), and the Tokyo Commodity Exchange (TOCOM). Investors in these exchanges speculate on the movement of the price of gold. The principal indicator is the spot price - the quote price for gold to be delivered and paid for on the settlement date two days into the future. The spot price is heavily influenced by the London fix.

Exit Gold, Enter Paper

Derivatives, instruments that settle further into the future than the spot settlement date, were introduced into the gold market to hedge against adverse movement in the spot price. There are two basic types of derivatives, although each has numerous complicated variations.

Futures are contracts to buy or sell a specified quantity of gold at a set price on a fixed future date. Delivery dates and unit quantities are standardized by the exchange. Futures trade is buying and selling futures contracts; physical gold is rarely delivered.

Options are a variation on futures that give the holder the right – but not an obligation - to buy (call option) or sell (put option) a specified quantity of gold at a set price on or before a specified date. Options are also standardized by the exchanges.

Out of the Exchange and Into the Stock Market

In 2003 the exchange-traded fund (ETF) introduced a form of gold trade into the stock market. These instruments are backed 100% by gold, although the holder never has possession of the physical asset. Similar instruments backed by futures are also available. Although ETFs may appear to simplify investing, they introduce another layer of risk while having none of the benefits of owning physical gold.