How do gold dealers make money?

Discussion of the Gold portion of the Permanent Portfolio

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Pointedstick
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How do gold dealers make money?

Post by Pointedstick » Mon Jul 15, 2013 7:06 pm

I'm trying to figure out how gold dealers stay in business when their product exhibits such unpredictable prices.

On the sell side, do they get merchandise drop-shipped at the spot price at the time the customer placed the order or something? Obviously they can't have a warehouse full of merchandise; they would buy at $1,500/oz and the next day it might fall to $1,400/oz.

And what do they do on the buy side? Say I walk into my friendly local ye olde coin shoppe with a Krug, I sell it for $1,500/oz, and the next day the price falls to $1,400/oz. Do they just hold onto it and hope the price rises? Or do they do something complicated like immediately enter into some kind of options contract with a wholesaler to sell it at the spot price or something?
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Re: How do gold dealers make money?

Post by stuper1 » Mon Jul 15, 2013 7:21 pm

I have wondered the same thing many times.  I don't have any specialized knowledge, so I could be way off base. All I can think is that at any given time, the number of buyers and sellers must be fairly even.  The dealer's profit is simply the premium between his buy and sell price.

Even as I write this, though, it doesn't really make sense to me.  It seems like when prices drop, there would be a lot more buyers than sellers.  And vice versa when prices rise.  Unless there are a lot more people out there than I can imagine who feel they must sell right away when prices drop, just in case they drop even further.
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Re: How do gold dealers make money?

Post by Libertarian666 » Mon Jul 15, 2013 7:24 pm

They hedge their inventory in the futures markets. That's why they get extremely annoyed when anyone tries to back out of a purchase after the price goes down, because they lift their hedge as soon as the sale is agreed to.
Last edited by Libertarian666 on Mon Jul 15, 2013 7:26 pm, edited 1 time in total.
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Re: How do gold dealers make money?

Post by Pointedstick » Tue Jul 16, 2013 12:54 pm

Libertarian666 wrote: They hedge their inventory in the futures markets. That's why they get extremely annoyed when anyone tries to back out of a purchase after the price goes down, because they lift their hedge as soon as the sale is agreed to.
Could you perhaps explain this in small words that a novice such as myself can understand? The futures market is somewhat of a mystery to me.
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Re: How do gold dealers make money?

Post by Xan » Tue Jul 16, 2013 1:09 pm

Yes, Libertarian666, please expand on this if you have time.  An example with precise (but made-up) dollar amounts would be really helpful.  This is something I don't understand at all either.
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Re: How do gold dealers make money?

Post by Libertarian666 » Tue Jul 16, 2013 2:32 pm

Sure. Let's say you are a gold dealer and you want to have 1000 1 oz. Eagles in your inventory. To buy them from your wholesaler, you have to pay the wholesale ask price, which let's say is $1300. If the gold price doesn't change, you expect to be able to sell them for $1350 each, making $50 apiece. So far, so good.

But what if you don't have buyers already lined up to buy them? Then, if the price goes up, great; you'll make more money when you sell. But if the price goes down, you could get killed.

Because you aren't a speculator, but a dealer, what you do is this: you sell nearby gold contracts on COMEX (the biggest commodity exchange). Let's say the nearest month that has any volume (so you can get a reasonable price) is September 2013. Each contract is for 100 ounces, so you will need 10 of them.

Each contract commits you to the sale of 100 ounces of gold for delivery in September. Let's say the September price is $1310. So you put down whatever deposit ("margin") the exchange requires, perhaps $10,000 per contract or a total of $100,000, to ensure that you will live up to your agreement. You might not want to do that if the gold price goes way up, as then you could get more on the cash market. The exchange guarantees the other party that they won't get burned in that case, and the deposit protects the exchange against your changing your mind. So you are effectively short 1000 ounces on the exchange.

Now let's say the gold price goes down $200. You are now in the red on your 1000 Eagles by $200x1000 ounces, or $200,000 in total. This could seriously ruin your day.

But wait! You are in the green by $200x1000 ounces on your gold short position, which by an amazing coincidence is the same $200,000, only positive, this time.

So the net result of this is that you don't care what the gold price does. You make your money on the spread between your buy price and your sell price, not on the fluctuations in the gold price.

That's what happens if you just buy your inventory and hold it. But what happens when a customer wants to buy some of your gold, say 100 Eagles?

You tell him "I'll quote you a price. If you agree, then you have to go through with the purchase even if the gold price goes down. If you try to back out, I'll charge your credit card for the difference, then stop doing business with you."

Assuming that the customer agrees, you then buy back one of your contracts, so now you are short only 900 ounces, but you are also exposed to the price on only 900 of your Eagles, as your customer has agreed to a fixed price for the other 100.

Does that explain it?
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Re: How do gold dealers make money?

Post by 6 Iron » Tue Jul 16, 2013 8:17 pm

Thanks for the explanation. That makes a lot of sense. It seems that the availability of physical gold for purchase has to be linked to "paper gold" via comex (and shorts thereof) for this business to exist.
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Re: How do gold dealers make money?

Post by Libertarian666 » Tue Jul 16, 2013 9:34 pm

6 Iron wrote: Thanks for the explanation. That makes a lot of sense. It seems that the availability of physical gold for purchase has to be linked to "paper gold" via comex (and shorts thereof) for this business to exist.
Yes, so long as gold is not used as money. But when it is used as money, there is no such thing as a "gold dealer"; they're called "banks".
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Re: How do gold dealers make money?

Post by Pointedstick » Tue Jul 16, 2013 10:22 pm

Libertarian666 wrote:
6 Iron wrote: Thanks for the explanation. That makes a lot of sense. It seems that the availability of physical gold for purchase has to be linked to "paper gold" via comex (and shorts thereof) for this business to exist.
Yes, so long as gold is not used as money. But when it is used as money, there is no such thing as a "gold dealer"; they're called "banks".
So a return to the gold standard would effectively nationalize the industry?  ;D
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Re: How do gold dealers make money?

Post by patricia26 » Tue Jul 23, 2013 6:15 am

Most of the time they hold it and wait to increase the gold and that is what they called wise decision.
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Re: How do gold dealers make money?

Post by Libertarian666 » Tue Jul 23, 2013 9:05 am

patricia26 wrote: Most of the time they hold it and wait to increase the gold and that is what they called wise decision.
No. They make money on the buy/sell spread. They are uninterested in the price other than if it affects the volume of transactions.
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Re: How do gold dealers make money?

Post by Larshus » Tue Jul 23, 2013 2:52 pm

99% correct. There are a few things missing though in the explanation of the hedge book.

1) There is no way to hedge premium risk. In a constrained market (often when you are most likely, or need to hedge) premiums go up. A dealer can be caught in a bind when he has to pay his wholesaler a inflated premium to take delivery sooner rather than farther out. For instance Lets say the mint slows down production on gold eagles. The tier 1 wholesalers will be in a position where their weekly allotments are cut. They will then charge a higher premium for live delivery, and a lesser (or normal) premium for delivery out into the future. This is akin to backwardation in the futures market.

Lets say that a dealer pays that premium and then hedges it by shorting near month futures. Now lets say that the next day the mint announces its not supply constrained any more and has unlimited eagles for sale. The premiums immediately drop to normal levels and the dealer is left to eat the difference in the premium paid.

This is why you'll see premiums explode in supply constrained markets. The wholesaler is charging more (because he can), and the dealer is charging more to cover his premium risk.

2) There are mini contracts that trade that are 33 oz. So you can get the granularity down to withing 33oz if you wish.

3) There is a lot more that actually goes on with margin and the futures trading that doesn't meet the eye unless you do it. For instance futures contract P/L are taxed COMPLETELY differently than physical gold. Futures are a mixed rate compared gold which is a collectible rate. There are ways to offset it but its complicated. There is a bunch of other assorted nit picky stuff that's a pain.. its not a completely transparent process.
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Re: How do gold dealers make money?

Post by Libertarian666 » Tue Jul 23, 2013 4:07 pm

Larshus wrote: 99% correct. There are a few things missing though in the explanation of the hedge book.

1) There is no way to hedge premium risk. In a constrained market (often when you are most likely, or need to hedge) premiums go up. A dealer can be caught in a bind when he has to pay his wholesaler a inflated premium to take delivery sooner rather than farther out. For instance Lets say the mint slows down production on gold eagles. The tier 1 wholesalers will be in a position where their weekly allotments are cut. They will then charge a higher premium for live delivery, and a lesser (or normal) premium for delivery out into the future. This is akin to backwardation in the futures market.

Lets say that a dealer pays that premium and then hedges it by shorting near month futures. Now lets say that the next day the mint announces its not supply constrained any more and has unlimited eagles for sale. The premiums immediately drop to normal levels and the dealer is left to eat the difference in the premium paid.

This is why you'll see premiums explode in supply constrained markets. The wholesaler is charging more (because he can), and the dealer is charging more to cover his premium risk.

2) There are mini contracts that trade that are 33 oz. So you can get the granularity down to withing 33oz if you wish.

3) There is a lot more that actually goes on with margin and the futures trading that doesn't meet the eye unless you do it. For instance futures contract P/L are taxed COMPLETELY differently than physical gold. Futures are a mixed rate compared gold which is a collectible rate. There are ways to offset it but its complicated. There is a bunch of other assorted nit picky stuff that's a pain.. its not a completely transparent process.
I stand corrected. Although I'm probably the most knowledgeable poster who hasn't been a gold dealer at one time.  :D
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Re: How do gold dealers make money?

Post by Larshus » Wed Jul 24, 2013 8:49 am

Its a hard way to make a living. That's why there are so few that have been around longer than 20 years. I can count on one hand the number that have been around more than one cycle. Its an extremely competitive business.
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