What is Paper Gold - inc. Gold Futures, Gold Options and CFD's

Written by Ian Davis - Bullion Manager • Last updated 3 Jan 2019

Gold is a great hedge against inflation and a means to preserve wealth. We are open advocates of physical gold ownership though owning paper gold is already better than holding all your wealth in your bank account.

Gold is one of the few investment options that has no counter party risk making it quite unique. Counter party risk is where an asset you own is at the same time someone else's liability. For example, bank accounts allow you to deposit money which is then used elswhere (often by the investment branch) and your deposits have become the bank's liability. Similarly, purchasing property often requires mortgages, bonds require corporations or governments to pay coupons and an ETF liability is with the fund you decide to invest with.  

Regardless of which gold investment you choose simply being invested in gold offers you financial security. Read on to find out more about each option.....

Paper Gold

Paper gold is a derivative of physical gold meaning it is in and of itself its own entity but still associated with gold. The link between paper gold and physical gold can come in the following forms:

  • Unallocated gold accounts (and in our opinion allocated gold accounts) - read more here
  • Exchange-traded funds (ETF's)
  • Gold Futures
  • Gold Options
  • Contracts for difference (CFD's)

In order to best understand this, we will briefly discuss what a derivative is. The dictionary definition of a financial derivative is as follows:

An arrangement or product (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset, such as a commodity, currency, or security.

In this case the underlying asset is gold and when purchasing paper gold you end up the proud owner of a piece of paper that acts as a substitute for physical gold itself!! This immediately causes us to become anxious but maybe that is just our predispotition. We discuss the options available and we have already published pages on ETF's and gold accounts. The others we discuss below: 

Futures, options and CFD's are a bet on the future gold price and depending on your contractural position you either short or long which is betting on a lower price or higher price respectively

  • Gold futures are a contract between buyer and seller betting on the future price of gold. The contract is set to a fixed value and at the expiry of the contract the buyer has an obligation to purchase the gold, stocks or other commodities at the agreed price.
  • Gold options are like future contracts but instead of an obligation to settle there is simply a right to do so. A second difference is an option often uses a "right to buy" value that a buyer has the option to trade at in the future which is a bit like a threshold value. For example, if the right to buy value is say £1000 once the contract expires if gold is at or above this threshold you have the option to buy and even if it rises to £1200 you can still buy at the £1000 price tag so if you think prices are going to skyrocket you can make some hefty profits along the way. Options also provide a little more flexibility for the parties involved and can even allow the buyer to sell the contract on rather than going through with a purchase and settlement. 
  • CFD's are very similar to gold future contracts but instead settlements are made through cash payments rather than via gold or stocks, commodities etc. 

All are understandably risky as you are simply betting on the future and no-one has a crystal ball. If your prerogative is to preserve wealth and if you are using gold as a safe haven, we don't believe paper gold is for you and you should consider physical gold ownership

Physical Gold

In our opinion, Physical gold ownership is the best way to own gold. You can see it, touch it, move it with you and trade it readily at any bullion dealer in the world. To add to this, you are not at the mercy of third parties remaining solvent and compared to future contracts and options you are certainly not taking on as much risk. The old saying "if you don't hold it, you don't own it" springs to mind and in the unlikely event of a catastrophic financial meltdown unless you physically hold your own gold then it is likely your investment will go up in a puff of smoke. 

Gold Britannia Stack

We could write an essay on the benefits of physical gold here and rather than duplicate content at this point we have a dedicated page discussing physical gold ownership in full.

Conclusion

The derivative market is a huge multi trillion-dollar business and I am sure many people make a fortune trading in it. It is also immensely risky and played a large role in the financial crisis of 2008 where banks were selling mortgage liabilities in such a way that masked the risks of default. I am not a fan of this type of investing and think it has a lot to answer for in the modern economy and as we are not using gold to make a quick profit, we do not partake in any gold futures or gold options trading. We own our gold to hedge against inflation, deal with currency fluctuations and stand clear of global geo-political turmoil. If this is the reason you are investing in gold, we highly recommend physical gold ownership

Added to this all paper gold has a counter party risk and this is a major reason we don’t own any. We do not like the idea of third-party liabilities affecting our investment and financial position, but this could be our lack of trust for others but given the state of financial institutions can you blame us!  

You may wish to view all of our articles on our gold guide