Thursday, May 15, 2008

The China Gold Derivative Market Part I: Gold Options Coming

This will be the first of a two or three part series of posts on the Chinese gold derivative market. I wanted to start with gold futures but I'm still checking that translation so enjoy this about this weeks announcement of gold options on the Shanghai Gold Exchange in the likely near future

Shanghai Gold Exchange Gold Options Plans

Shanghai Gold Exchange Will Soon Roll Out New Products

Jinrong Jie (Finance World)

May 13, 2008

Zhou Jingzhen

Translated by China Gold News Blog

http://chinagoldnews.blogspot.com

The Shanghai Gold Exchange is rolling out new products aimed at investors not familiar with gold investment products—experts see gold options as easier to avoid losing money.

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In the past few days, Shanghai Gold Exchange Chairman and Party Committee Member Shen Xiangrong stated that the Gold exchange is thinking of introducing physical gold options. After this information was released it immediately peaked the interest of many investors. Even so, what are the features of gold options as compared to the current types of gold products? Also, how will investors buy gold futures? Some knowledgeable experts present their views on this.

Views on Gold Options

Shen Xiangrong on May 10 at the “Lujiazui Forum” revealed this information. According to him, currently many types of investment products have very high risk. When they rise they shoot up and when they fall they collapse. There is not a hedging instrument. If someone has both futures and options, it is much better. Right now the gold futures have already been introduced but if physical gold options will be introduced, they will also be very useful. Options have low fees and if they rise, profits can be very high but if they fall the investor only looses their upfront payment. The fluctuations in the gold prices have been very large. In March, the spot price’s highest point reached over 230 RMB per gram while now it has fallen to about 180 RMB per gram. If you have options, then you could reduce such risks. The option price is small and investors have limited losses and the risks are fixed from the beginning.

Jiangsu Central Bank Already Has Similar Products

Many investors do not understand gold options. Experts at the Jiangsu Central Bank say, gold option trading is the purchaser buying the right from the options seller to buy or sell physical gold or futures. These are divided into call options or put options. For investors who engage in option trading, you only need a small investment but can have large returns with limited downside risk giving the products a guarantee aspect. The buyer only has to pay an option price and can then has the right to buy or sell the products or futures. Generally investors predict market changes that can be exploited for considerable profit. If their prediction is wrong, they can just abandon exercising the option and only lose the option fee. Suppose that right now the international gold price was $600/oz. and a customer buys a call option contract to buy gold at this price in ten days. If ten days later gold is at $650/oz., the customer can still buy gold at $600/oz. from the bank. If the price falls, the customer can just choose not to exercise the option but looses the call option fee.

In fact, as early as March 1, Jiangsu Central Bank introduced personal gold options trading and it was in order to be involved in international market positions and alleviate RMB and US dollar exchange problems. The service was restricted to US dollar products. It is understood that on March 7, two traders new to options bought two 3-month call options for 1,100 and 770 ounces expecting appreciation. The two investors saw gold’s rise “based on the contract, if at the expiration date, the US dollar price exceeds the strike price, the bank keeps the option fee as its profit” an official from the bank’s capital division stated. For example if one of the investors with the bank signed a $675 per ounce option contract, for 1,100 ounces, the bank would charge an option fee of $33,000. On June 1, if the gold price hits $705 per ounce then the customer could break even. If gold hit $730 an ounce then the customer would get a profit of $25 * 1,100 ounces of $27,500. But what if in that period gold doesn’t rise or falls? He says, that if the gold price actually falls then certain positions will be under given the price did not rise to the contract strike price. In this case, the bank will recommend that the investor sell the contract before the expiration date and not go so far as to lose the entire option fee.

Experts Analyze Investors

The Xihanzhi International Gold Company’s expert on “paper gold” (Ed. “paper gold” -- gold security investments often sold by Chinese retail banks to customers that are tied to gold but that do not guarantee physical delivery) said that the profit returns from paper gold and gold options are about the same. Suppose that in the first case an investor buys paper gold and in the second case the investor buys a gold call option. In different situations the profit/loss result will not be the same for each. If you first buy 100g of paper gold for 150 RMB per gram you must pay 15,000 RMB. If you at the same time buy 100 1-month call option contracts at a strike price of 155 RMB (1 contract is for 1 gram of paper gold) at an option fee of 3 RMB each you will invest 300 RMB. Three situations can result:

1) If the spot gold price reaches above 158 RMB/gram

If the spot price of gold hits 161 RMB than the option contract value becomes (161-155) = 6 RMB for a profit of 600 RMB. Your return is (600-300)/300 = 100%. If you had invested in paper gold for 155 RMB per gram the profit is the same.

For the paper gold bought at 150 RMB/gram the return is 1100 RMB/15,000 = 7.33%

2) If the spot gold price is between 155 and 158 RMB

At this point the option still has value although it does not reach the investors break-even point. However, one can sell the contract to lower the losses.

For example, if gold were at 157 RMB/gram at this time the option would be worth 2 RMB each for a total of 200 RMB and in the end this investment would have a loss of 100 RMB.

3) If the gold price is lower than 155 RMB

In this case the value of the option is 0. The investor should not exercise the option and incur losses of 300 RMB. The paper gold the investor purchased is also in a losing position.

This is a small reminder that the options limit risk and are invalid after the expiration date. Moreover, though paper gold values can still exist, the investor needs more capital compared to buying an option. Also, the carrying risk of holding paper gold extends to the entire value of the gold while the risk for the option is solely the option fee.

Hedging Using Both

As physical gold and paper gold are not completely the same, gold options can be bought low and can be used as protection for paper gold investors as part of a portfolio.

This expert continued to explain: suppose that gold prices were at 150 RMB/gram, and a call option at 150 RMB/gram from the bank for a one month period costs 3 RMB per contract (contract for 1 gram of paper gold). If there is not a situation where gold falls below 150 RMB/gram then you exercise the option to buy the gold. Generally when gold falls below this level the investor will start losing money with the entire 150 RMB purchase price potentially at risk.

If in buying paper gold, at the same time you can buy relative protection by also purchasing gold put options. The exercise price of the put option is also 150 RMB. If gold falls below 150 RMB the put option will start acting as a hedge against paper gold losses.

No matter how far the gold prices fall, the put options give option holding investors the right to sell paper gold at 150 RMB. For this reason the price decline risk is limited to only 3 RMB. The total cost of the gold and option is 153 RMB while reduce the risk by 150 RMB. The advantage of this strategy is it allows investors protection from downside risk. At the same time, there is unlimited upside for the 153 RMB initial investment. The only drawback is that gold prices must reach at least 153 RMB before investors start making a profit.

The Risk is Smaller than that for Gold Futures

As compared to gold futures, the risks of gold options are relatively small. When investing in gold futures, the customer immediately faces a risk of not meeting the margin requirement. When opening a position that makes the investor face immediate market fluctuations, it is convenient to have appropriate expectations and be able to add to your margin account at a moment’s notice. Otherwise, this trade could potentially overwhelm your position. Customer potential losses are not limited to the upfront margin, but all funds the account holder has. Because the Chinese gold futures market changes are influenced by international market fluctuations, there are frequently fluctuations due to overnight trading in New York (Ed. China’s time zone is exactly off NY by 12 hours). For this reason, it is rare for the domestic gold prices to not experience sharp jumps. Therefore, investors positions have an increased trading risk as well.

In summary, when trading gold options, the customer is already certain upon purchase that the largest losses that can be incurred are the option fee that is paid to the bank. In the future, no matter how the gold price fluctuates, the customers greatest possible losses are already certain. Only within the option exercising period (up to the expiration date) can market fluctuations profit the customer and customers can choose the point at which to exercise the option and lock in their profits. Before then, they do not have to worry about the large negative fluctuations in the market.

(Editor: Huang Wenting)

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