Precious Metals Arbitrage

Precious metals arbitrage involves exploiting price discrepancies in the market for precious metals like gold, silver, platinum, and palladium.

Arbitrage strategies can be implemented across different markets, exchanges, or products to capture risk-free profits.

These strategies leverage differences in prices that should not exist in efficient markets due to supply and demand equilibrium.

Key Takeaways – Precious Metals Arbitrage

• Market Discrepancies
  • Precious metals arbitrage capitalizes on price differences across markets or products.
  • True arb represents risk-free profit opportunities.
• Government Restrictions
  • Historical and current regulations on precious metals often create arbitrage opportunities due to artificial price controls.
    • E.g., Bretton Woods, gold ownership restrictions throughout history
• Diversified Strategies
  • Use various tactics like futures contracts, ETFs, and physical metal trading to exploit relative price movements and manage risk effectively.

Types of Precious Metals Arbitrage

1. Spatial Arbitrage

Spatial arbitrage, also known as geographic arbitrage, involves buying a precious metal in one market where the price is low and simultaneously selling it in another market where the price is higher.

Example

Purchasing gold in London where it is undervalued compared to New York and selling it in New York.

It’s typically around $0.20/ounce to fly gold from London to New York, another $0.20/oz to melt the heavier London bars and get them to match New York delivery standards, and around $0.10/oz for financing. There are also costs of chartering the jet to take into consideration.

2. Temporal Arbitrage

Temporal arbitrage takes advantage of price differences over time.

This typically involves entering into contracts or using derivatives.

Example

Buying gold futures contracts for delivery in the future when the current spot price is lower than the future price adjusted for carrying costs.

3. Inter-exchange Arbitrage

This strategy involves exploiting price differences for the same precious metal across different exchanges.

Example

Buying gold on the COMEX (New York Mercantile Exchange) and simultaneously selling it on the Tokyo Commodity Exchange if a price discrepancy exists.

4. Product Arbitrage

This strategy exploits price differences between different forms of the same precious metal, such as coins, bars, and ETFs.

Example

Buying physical gold coins at a discount to the spot price and selling gold ETFs that are trading at a premium.

Arbitrage Mechanisms

1. Spot and Future Prices

Arbitrageurs might buy precious metals in the spot market and simultaneously sell futures contracts when futures prices are higher than the spot prices plus carrying costs (storage, insurance, and interest).

2. ETFs vs. Physical Metals

Arbitrage can occur between the prices of ETFs (e.g., SPDR Gold Shares) and the actual physical precious metals they represent.

If the ETF is trading at a premium to the physical metal, arbitrageurs might sell the ETF and buy the physical metal, expecting the prices to converge.

3. Currency Arbitrage

Currency fluctuations can create arbitrage opportunities in international markets.

For example, if the exchange rate between USD and EUR changes in a way that affects the price of gold in Europe versus the US, arbitrageurs can exploit this discrepancy.

The price of gold and precious metals is always represented relative to a base currency – i.e., a certain number of units of currency (dollars, euros, yen, etc.) per amount of the metal (e.g., ounces).

Key Things to Keep in Mind

1. Transaction Costs

Arbitrage opportunities must exceed transaction costs (commissions, taxes, storage costs) to be profitable.

2. Market Liquidity

Sufficient liquidity is necessary for executing arbitrage trades quickly to capture price discrepancies before they close.

As a trader, it’s always important to know how you’re going to trade something in the most efficient way possible – i.e., ETF, futures, etc.

3. Regulatory Constraints

Different regulations in various markets can impact the feasibility of arbitrage strategies.

Understanding the legal environment is essential.

4. Risk Management

While arbitrage is often seen as risk-free, execution risk, price slippage, and changes in markets can introduce risks.

Historical Context of Precious Metals Arbitrage

The concept of arbitrage is well-documented in financial history.

For example, during the breakdown of the Bretton Woods system, significant arbitrage opportunities arose due to discrepancies between gold prices in different markets. 

In the lead-up to taking the USD off the gold standard in 1971, gold was artificially undervalued due to the fixed exchange rate system established by the Bretton Woods Agreement.

Under this system, the US dollar was pegged to gold at $35 per ounce, while other currencies were pegged to the dollar.

This arrangement led to an undervaluation of gold because market demand for gold exceeded the fixed price, driven by inflationary pressures and rising US debt from the Vietnam War and domestic spending programs.

As foreign central banks accumulated more dollars, they increasingly exchanged them for US gold reserves, depleting the US gold stockpile.

This situation created a significant arbitrage opportunity:

• speculators could buy gold at the official price of $35 per ounce and sell it in free markets, such as in London, where the market price reflected higher demand and inflation

This scenario demonstrates a classic form of precious metals arbitrage, where the fixed price set by the gold standard diverged from the free market price.

Arbitrageurs capitalized on this discrepancy until President Nixon’s decision to suspend the gold convertibility of the dollar, effectively ending the gold standard and allowing gold prices to float – therefore correcting the artificial undervaluation and eliminating the arbitrage opportunity.

Precious Metals Arb Happens Repeatedly Throughout History

Precious metals arbitrage has a long history, largely driven by government-imposed restrictions on gold and other precious metals.

These restrictions often aimed to protect national currencies and control credit.

By and large, policymakers don’t want private forms of money competing with their own.

Similarly, during times of economic turmoil or war, governments frequently restricted gold ownership or imposed price controls to prevent capital flight and maintain monetary stability.

These artificial constraints led to discrepancies between official and black market prices, enabling arbitrage.

Such practices are evident in various historical contexts, including the Roman Empire’s debasement of currency and the gold standard adjustments in the 20th century (including 1933, which we cover in our articles on the history of money and reserve currencies).

Each instance reflects governments’ attempts to control money supply and credit, inadvertently creating arbitrage opportunities for traders who exploit the price differences arising from these interventions.

Thus, precious metals arbitrage persists as a response to governmental attempts to regulate and control monetary systems.

Precious Metals Spreads

Precious metals spreads are closely related to precious metals arbitrage.

Spread trading involves taking advantage of perceived valuation discrepancies and isn’t risk-free (like traditional arbitrage) because such spreads might not close or even widen (and lead to losses for those betting on their close).

Precious metals spreads involve trading the price differences between metals like gold, silver, platinum, and palladium to profit from relative price movements.

Key spreads include:

Gold-Silver Spread

Measures the price ratio between gold and silver.

Traders buy the undervalued metal and sell the overvalued one when the ratio deviates from historical norms.

For example, if the ratio is historically 60:1 but currently 80:1, traders might buy silver and short gold.

It’s also an indication of economic conditions – silver is used more for industrial reasons, so the spread tends to tighten during good economic times and widen during less secure economic times (but not always, as supply is a factor and there are other forms of demand).

Platinum-Palladium Spread

Involves the price difference between platinum and palladium, influenced by industrial demand.

Traders short palladium and buy platinum if palladium prices spike due to increased automotive demand.

Gold-Platinum Spread

Tracks the price difference between gold and platinum.

Traders exploit deviations from historical norms, considering industrial demand for platinum and safe-haven demand for gold.

Trading Mechanisms

• Futures Contracts – Used on exchanges like COMEX and NYMEX for leveraged positions.
• Options – Provide flexibility to hedge or speculate, limiting downside risk.
• ETFs – Offer exposure to metals, enabling spread trading through buying and shorting different ETFs.
• Physical Metal Trading – Direct exposure, useful for long-term hedges or strategic reserves.

Key Factors

• Market Liquidity – Important for efficient trade execution.
• Transaction Costs – Must be factored into profitability.
• Market Correlations – Understanding correlations between metals is vital.
• Macroeconomic Factors – Impact spreads, requiring continuous market monitoring.

Conclusion

Precious metals arbitrage is a sophisticated strategy that requires a deep understanding of market mechanics, effective execution, and rigorous risk management.

Successful arbitrageurs capitalize on market inefficiencies to generate profits, contributing to market equilibrium in the process.