Have you been watching gold and silver? Both of these precious metals (see charts at right) have captured the attention of traders, including the beginner contemplating their first step into a new market. Whether you believe that gold or silver is heading higher or lower, there are a variety of instruments available to trade your price prediction. Some, like binary options on gold, are relatively recent financial innovations. In what follows, several instruments are compared across a range of relevant metrics. Which is best from a trading perspective will depend upon your price expectation, tolerance for risk and available risk capital.

 
Bullion Coins

Bullion coins are highly refined precious metal products produced by federal governments throughout the world specifically for investment purposes. Bullion coins are legal tender in the issuing country for the coin's face value and can have a market value above this based on the value of their content metal. Gold and silver coins are long-term bullish investments and would be considered only by a trader who is anticipating an increase in price of the precious metals. (Coins cannot be sold short.) The advantage of buying gold or silver bullion coins is that the minimum purchase is usually set low enough so as to be accessible to most traders. However, the trader will pay a dealer mark-up that can be significant for low quantity orders as well as shipping and handling fees, all of which deteriorate tracking performance. In addition, the liquidity of coins (ease of selling the coins at a future date should the trader decide to do so) is probably a greater concern than for any of the other alternatives to be discussed. Bullion coins should not be confused with commemorative coins whose value depends upon their rarity, design and finish rather than their metal content. These are not logical candidates for trading a price prediction of the underlying metal.
 

Physical Bars

A gold or silver bar is broadly defined as a cast or minted item made by a recognized bar manufacturer. Like coins, bars provide a way to trade only one side of the market: the long side. Unlike coins, a purchase of physical bars is capital intensive. For example, while gold bars vary in content, the kilobar (1,000 grams) is the world’s most widely manufactured and traded small gold bar. If gold is trading at $1,300 per ounce (1 troy ounce = 31.1034768 grams), then a kilobar would cost around $41,800 plus dealer mark-up and fees. Bars are sold at a premium or mark-up above the prevailing value of their metal content (though the premium is often less than that of coins) and this along with the ongoing cost of storage and insurance associated with ownership of the physical metal impacts tracking performance, though tracking is still good. Because the purchase is non-leveraged, the risk is low: at most only the initial investment can be lost. Liquidity is fair because of the transaction procedure and expenses associated with selling the bars at a later date though this depends in part on where the bars are stored.
 

Exchange-Traded Funds

Exchange-traded funds, or ETFs, are bought and sold on a regulated exchange and through a brokerage account much like individual stocks. Using market and limit orders, shorting, and buying on margin can be done with ETF shares in the same manner as with a stock. ETFs that are based on gold or silver allow a trader to go long or short these markets, though shorting is not as efficient as with other investment alternatives to be discussed. Individual shares are priced low enough to be affordable to most traders. Because of tax considerations, ETFs are not ideal for trading over the short-term. Tracking performance will depend in part on how the ETF gains the gold or silver exposure (ie., with physical metal or with futures contracts) and may differ among ETFs so the trader needs to do sufficient research. Liquidity as well may vary among ETFs and any ETF may be subject to heightened liquidity concerns, for example, during times of massive share selling. Poor liquidity will negatively impact tracking performance. (See also ETFs vs Futures.)
 

Regular Futures Contracts

Gold and silver futures trade on the COMEX Designated Contract Market of CME Group. Prices of these futures tightly follow the respective cash prices because of active arbitrage and this plus high liquidity and low, dollar-based transaction expenses (instead of principal-based dealer mark-ups) makes tracking performance of futures arguably the best of all instruments considered. Tracking will not and could not be perfect with the cash price, though, due to storage, insurance and transaction costs associated with the physical metal. These costs are incorporated into the forward premium of the futures price above the cash price. In other words, buying the futures (with a decaying forward premium) should provide essentially the same return as holding physical gold after including these costs. Futures are a leveraged instrument meaning that the cash investment is much less than what would be required for an equal exposure in the physical metal. For example, a 100 ounce gold bar requires an investment of $160,000 (if gold is trading at $1,600 per ounce) but buying one gold futures provides the same exposure at a cost of only $11,475 as margin. (Source: CME Group. Margin is as of January 4, 2012 and may change.) Leverage has the effect of multiplying rates of return. For example, if the gain associated with an investment in physical gold is 2%, then a futures contract that has leverage of 14:1 would produce a gain of 28% relative to the required margin. Since percentage loss is also magnified, leverage makes futures a risky investment. High liquidity coupled with tax considerations make futures the investment vehicle of choice over the short to medium-term for metal bulls and bears alike. (Request our package of Gold & Silver Trading Guides. See also How to Invest, Learn Commodity Trading and Day Trading Futures. You can learn how to trade gold and silver futures, along with other futures, in our futures trading course for the beginner called Commodity Trading as a Second Income.)
 

Smaller-Sized Futures Contracts

CME Group lists various contracts on gold and silver that are similar to their regular-sized counterparts but have a smaller contract size. COMEX miNY gold futures have a contract size of 50 troy ounces, E-mini gold futures have a contract size of 33 troy ounces, and the relatively new E-micro gold futures have a contract size of just ten ounces of gold making it the most affordable. (See E-micro gold futures.) COMEX miNY silver futures have a contract size of 2,500 troy ounces while E-mini silver futures have a contract size of 1,000 troy ounces. A smaller contract size means less risk and correspondingly, a smaller margin requirement that, in turn, makes the contract more appropriate for the investor who has less trading capital or less tolerance for risk.
 

Buying Options on Futures

Options on gold and silver futures enable a variety of trading strategies to best match the investor's price expectation and level of risk capital. For beginners, it is recommended to confine trading to buying options: buy a call if prices are expected to rise and a put if prices are expected to fall. This is low risk since the most that can be lost is the initial investment which, depending upon the option strategy, can be relatively low. Option prices incorporate a time value above and beyond the intrinsic value and it is the decay of this time value that reduces tracking performance and, for the option buyer, argues in favor of a short or medium-term trading horizon. If the cost of a simple put or call option purchase is considered to be too expensive, the investor can instead buy option spreads. A bull call spread is bought when prices are expected to rally and a bear put spread is bought when prices are expected to fall. Each of these spreads is constructed by simultaneously buying one option and selling another. The option sold helps to offset the cost of the option purchased, thus making the trade more affordable. (See also Buying Gold Call Options and Bull Call Spreads and Buying Gold Put Options and Bear Put Spreads.)
 

Binary Options