"Gold has been the single biggest winner for our clients over the past year," says Simon Denham, managing director of spread-betting firm Capital Spreads. That's not surprising, as spread betting has long been one of the simplest ways of speculating on the gold price. Indeed, the letter 'G' in IG Index refers to gold. An index based on gold was the first product offered by IG when the idea of financial spread betting was first mooted in 1974.
Back in the 1990s, the bid-offer spreads you would have had to pay to open and close a position would have been huge. But bullion spreads have come right down now. For example, IG Index's spread bet on gold is around 0.6 points (560.0-560.6 at the time of writing) and City Index's is 0.8 points. Most spread-betting firms make prices in gold, but check before you open an account just to make sure.
It is important to note that by denominating the bet in sterling, you are getting exposure to the movement in the price of gold, but not to the underlying dollar exchange rate. In other words, your £1-a-point bet on the gold price pays out based on the movement in the dollar price, but your winnings are in sterling. There is no need to translate the dollar value into and out of sterling in order to work out your profit (unlike gold CFDs, which are priced in dollars per point).
The drawback of spread betting in gold is that it is not really designed to be a long-term investment medium. Gold spread bets are based around futures prices, and have expiry dates - usually a month or two hence. Although bets can be rolled forward from one expiry date to the next, this does entail a cost. So spread betting on gold is best confined to situations where you believe that the short-term price is out of line with events. Bear in mind, also, that spread bets are margin-based products and it is quite easy to lose more than you invest. Take advice if you are unsure, and consider using guaranteed stop-losses.
The typical gold spread better is usually "much longer term than our other clients", notes Mr Denham. Gold punters tend to take out bigger positions, too, with an average trade in gold of £6.30 per point, compared with the average bet size of £4.50 per point. Gold bets now account for 2 per cent of all trades. It seems that interest in commodity bets is coming at the expense of spread betting on indices.
One of the fastest growing financial products, are so-called Contracts for Difference, commonly known as CFDs. They allow investors to do exactly as the name suggests: enter a contract with a financial entity to exchange the difference between the opening value and the closing value of a financial asset (in other words: you are trading the difference between the two).
Some of the specialised financial service providers have significantly expanded the range of assets for which CFDs can apply, including listed stocks, a bond, a future, an option or a currency and even certain indices.
CFDs are in essence a geared risk instrument. Their fast growing popularity is due to the fact that they’re not complicated to understand (unlike their risks) and the fact that they allow retail investors to leverage their positions up to twenty times (meaning they can win twenty times the amount of a profitable trade, minus costs). These are instruments for short term risk traders.
Some CFD providers offer the opportunity to trade the spot gold price via CFDs.
A warrant is a form of call option. Covered warrants are close cousins of traded options. And, like options, warrants come in two main varieties: call warrants and put warrants. These give you the right, but not the obligation, respectively, to buy or to sell gold at a specific price before known expiry dates.
As with options, most investors trade warrants during their life, rather than hold to expiry or exercise them. The big plus is that they trade on the London Stock Exchange, use conventional EPIC codes and settle in CREST. As a result, most private client stockbrokers and nearly all online brokers will deal in covered warrants.
Another feature is that expiry dates are generally somewhat longer than for Liffe options. In the case of the gold market, there are covered warrants available now that have expiries just under a year ahead.
Last, but not least, bid-offer spreads are tighter on covered warrants than you'll find in many parts of the options market - and the LSE has instituted a rule on maximum spreads on covered warrant prices.
So what's on offer? The answer is a pretty select range of products. Here are a couple of examples. SG, probably the largest player in the market, currently has two call warrants listed with strike prices of 450 and 500, and a put warrant with a strike price of 500. In all cases the expiration date for the warrant is 15 December 2006.
So let's suppose that you think gold will continue to rise and will hit $650 an oz by the end of the year. SG's Christophe de la Celle explains how a call and a put on gold might work.
"Such an investor could buy the $500 Dec 06 call warrant (TIDM SB12). This warrant would allow an investor to purchase an ounce of gold at $500 an ounce regardless of the gold price in December." Unlike options, warrants are cash-settled, so that if your warrant expires 'in the money' in December, you would not receive an ounce of gold at your doorstep, but the cash difference between the actual gold price and the warrant's strike price of $500.
With the gold price currently around $560, you can buy the $500 gold call for 58p (note that warrants are priced in pence even when the underlying is priced in dollars). And let's say that, come December, gold is trading at $650. At expiry, the payout for each warrant will be calculated as follows:
(Gold Price - Strike Price)/Warrant Price = $650 - $500/100 = $1.50.
You divide the cash difference by 100 as this is the warrant's parity level. It allows covered warrant issuers to quote the warrants in pence rather than in pounds and has no effect on the warrant's value. In other words, one warrant gives you exposure to 1/100th of an ounce of gold.
Under this scenario, the warrant would be worth $1.50. However, as gold warrants are dollar products that are listed in pence, you have to convert this value into sterling at the prevailing exchange rate (let's assume a rate of £1= $1.70).
Under this scenario, each warrant would be worth 1.50/1.7 = 88p, giving a return of 51 per cent on the warrant from 58p to 88p on the back of a 14 per cent increase in gold (from $568 an ounce to $650 an ounce). This leveraged exposure is possible because you need only invest a fraction of the price required to gain exposure to one ounce of gold. However, if gold were to trade below $500 at expiry, the warrant would expire worthless.
As with other derivatives, you can also use warrants to take a bearish view on gold by buying a put warrant. In an ideal world, there would be a wide range of put warrants with different strike prices. As it is, the put warrant with the strike price closest to the current price is the SB97 warrant with a $500 strike and December 06 expiry. With gold at $568/oz, each warrant costs 9.25p.
If at expiry, gold has dropped to $450/ounce, your payout would be calculated as follows:
(Strike Price - Gold Price)/Parity = $500 - $450/100 = $0.50 per warrant.
In sterling terms, the warrant would be worth 29p. This represents a return of 213 per cent for a 21 per cent drop in the price of gold. However, if the price of gold were above $500 at expiry, the warrants would expire worthless. It is important to note however that warrants do not need to be held until expiry, but can be sold at any time beforehand if you wish to lock in your profits or cut losses.
The normal rule for trading and valuing options apply in much the same way to warrants. You can't lose more than you invest, and the upside is geared if the price moves the right way. In the case of the SG call warrants, effective gearing to the underlying gold price is between four times and 10 times.
Hedge funds have been getting most of the headlines recently, and not necessarily for the happiest of reasons. But there is another type of investment that is quietly taking off: the exchange traded fund (ETF).
In the past, investors were faced with a simple choice: either they put their money in actively managed mutual funds with hefty fees and no guarantee of performance, or they could buy an individual company share with all the attendant risk.
But the arrival of ETFs has given investors a third option. Now, they can invest in specific sectors of the stockmarket, or into certain geographical areas, with much lower management fees than conventional funds and less chance of significant tracking error.
The first ETFs came into being in the US in 1993 and were benchmarked against the S&P 500 stock index, probably the most relevant index for investors seeking a representative snapshot of the health of the US economy. These proved so popular that a raft of new ETFs soon followed. The Dow Diamonds, benchmarked against the Dow Jones Industrial Average, was created in 1998, followed by various specific sector ETFs.
ETFs have become increasingly popular with investors disillusioned with the cost and performance of actively managed funds. Investors like the fact that ETFs have lower expense ratios, are more tax efficient and more flexible than funds. But ETFs aren't so popular with financial advisers, who have little opportunity to earn big fees from them.
Many market participants find ETFs a great way to achieve low-cost portfolio diversification, both for the passive and more actively inclined investors. Indeed, hedge funds are major buyers of ETFs. So ETFs offer a user-friendly way for the little guy to play on a level playing field with the City and Wall Street professional.
This article was first featured in the autumn issue of Investors Chronicle Magazine