JLN Metals Editor Chris McMahon recently spoke with Noble DraKoln, founder of the Speculator Academy and author of both “Wining the Trading Game” and “Trade Like a Pro.” DraKoln, a 17-year veteran of the gold trade, also recently published a white paper that compares the pros and cons of trading gold futures vs. gold exchange traded funds. The following is the first of two parts.

“There are pros and cons to any kind of trading, but futures are the best place to get a competitive edge,” says Noble DraKoln.

McMahon: Give us an overview of the similarities and the differences between gold futures and exchange traded funds.
DraKoln: “The main similarity is that they both key on the gold metal and, as we all know, gold has been having a huge impact on the economy world wide. People have been driving their investment money to safe havens based on what has happened with the mortgage crisis as well as what’s going on with certain currencies: the euro being weaker now, the dollar having been weak for so long. After that, the similarities start to separate very quickly.

When you get involved with ETFs, they become almost a proxy investment. You don’t get the real operation of gold itself unless you are trading the futures, the options or physical gold; it’s really hard to catch the moves with the ETF.

Why is that? Please explain.
“When people invest or trade gold or the gold contracts, you get an opportunity to interact with the banks that actually use gold futures to hedge their positions or to shore up their investments. When you start looking at the ETF side, there are a lot of things that happen on the back end of ETFs, that are only particular to ETFs. As we see nowadays, ETFs have had to add or decrease their positions to shore up their gold reserves, so they are really a proxy of the gold contracts.

A lot of people would like to avoid gold futures and ETFs, but they can’t afford to go out and buy the actual physical gold, so leverage is one part of it. If someone wants to buy $1,000 worth of gold, you can do it in an ETF and get 10 units of an ETF, or approximately one ounce. Or you can take that same $1,000 and buy one of the mini contracts of gold and get more ounces per share. But take it one step further, the way the management is set up for the ETFs is that the gold itself is being held in reserve by the company, so if they decide to liquidate to cover marketing costs, or any other expenditures particular to the ETF company, then that comes right out of the gold reserves and affects the percentage ownership of the people trying to trade the ETFs. I read an article the other day that said that since ETFs are traded mostly by institutional investors, the institutions can affect the ETFs dramatically by selling off their holdings and then the ETF has to sell of a portion of it’s holdings to maintain balance. That’s big, and it’s another whole issue that’s separate from just participating in the marketplace.

I saw that, that was the Credit Suisse story, where they said ETFs have changed the supply and demand patterns.
“Yes. There’s nothing wrong with the concept of the ETF, and in fact small investors have been looking for something like this for years to give themselves a sort of entry way into what they thought the rich and elite were participating in. But when you are looking at ETFs buying gold holdings for no other reason than to resell them, representing themselves almost like a bank or country in order to sell it to the investing public, that’s a whole different paradigm. It’s not pure supply and demand, it’s more of a hoarding.”

How are the ETF and futures markets different? How do the sizes of the markets compare and is that important?

“You start looking at the tonnage of gold that is out there, you start to see that the futures contracts themselves represent, and it fluctuates, representing maybe 10% to 15% of the gold that’s out there. But when you look at the ETFs, they are a drop in the bucket compared to the total nominal value of the gold futures contracts that are out there. Then you take another step out and look at all the gold that is being traded and the total number of participants and start to realize that your level of liquidity is really on a small scale compared to what else is out there.”

ETFs have to have something going for them to have attracted so much investor attention. What do you attribute that to?
“It’s the buzzword of the day, exchange traded fund have been great for emerging markets. When you start talking about China or any place where it is difficult for any individual investor to put up their money and price it, then yeah it’s a great idea.

What’s happened is that ETFs have evolved into the metals sphere and the commodities sphere; you have the agricultural ETFs and silver ETFs and the gold ETFs that I am talking about, that have been touted as a cure all for everything, and when you push it out there, investors who were afraid of trading futures immediately started thinking ETFs were a great alternative, not realizing that they are almost a back-door way for them to participate. And it’s removing them from the true commodity. And I feel the same way about mining stocks. When you talk about mining stocks and mining companies, a lot of investors tout them as a great way to get involved with gold, and they don’t realize that not only are they gaining the burden of the commodity, whatever that may be, but they are also getting the burden of the management of that particular company and that’s why the value of the mining stock might not match the the value of the underlying.

In ETFs, you have the same problem and ETFs have problems that go beyond just the underlying commodity. If they were a pure commodity play, that would be great. Unfortunately, they are not. Instead of participating in the underlying product, you are three tiers removed. You have the ETF that selects the mining companies, you have the mining company’s management, and then finally you get to the active participation in the product itself; so this removes people from what their original intent was, which was exposure to the underlying.”

Let’s talk about the affect of currency values on gold.

“The U.S. dollar used to be pegged to gold and you could exchange them for gold, now we have a fiat currency. Eventually we got to the point where $34 dollars was pegged to one ounce; that was the standard until the 1970s. It was fixed and it will probably be another two generations before people separate physical gold from fiat currency the way we know it. The problem we have now is that gold, the dollar and oil are all running pretty much in tandem. Since we went off the gold standard, we saw a ten-times jump in gold and oil prices. I always tell people that there is an interrelationship between gold and oil because that is the default purchase of oil producing nations; they buy gold. They buy it in U.S. dollars and they buy it in euros; they try to convert them into gold.

But on an individual basis, a lot of people get burned because they don’t have a long-term strategy for gold. The assume it’s an inflation hedge or they assume it’s for currency protection. But then what happens is like today, it broke some key support and resistance levels and we realize that gold has found a new peg. Instead of responding to the strength of the dollar, it responded to the weakness of the euro and as the euro dropped, gold dropped [as priced in U.S. dollars]. It’s not as fun to run to gold for protection for those people who are primarily in the euro. It’s always based on perspective.

When you talk to most people, they say gold is a hedge against inflation, but we don’t have inflation, and despite the our economic problems, the dollar continues to rally.
“Gold, whether we like it or not is the default currency. Our focus, and what we always teach people is that you focus on the trade, not everything around it. Otherwise you make assumptions that can’t quickly change. Today we see that because the U.S. economy is weak, the dollar gets strong and the stock market pulls back and gold starts to pull back. But this kind of relationship hasn’t always been there and it’s not always going to be there, so we have to be flexible in how we perceive gold investing.”

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