The various futures exchanges provide an important function that many don't know about. Let's say a person is a corn farmer. Farmer believes that the price of corn is going to go up in the fall/winter, so he plants a huge amount in the spring. But the farmer worries that if the price drops, he is gonna be up $h*t creek so to speak since he committed all his fields to corn, so he also buys put options on corn futures or even goes short on a certain number of corn contracts as insurance in case his prediction about higher prices is incorrect. If the price does drop he receives less for his crops, but his futures "hedges" make him a profit so he is OK.
Many industries rely on futures markets to "hedge" whatever it is they trade in, as well as ensuring that they have a supply of whatever commodity it is they need and lock in prices that they find acceptable at any given point in time. If a company needs cotton for example to make clothing and the price is now low, they can lock in and be guaranteed that they will not pay a penny more for that cotton when the delivery month approaches.
Although a long (buyer) may demand delivery of the underlying commodity, the vast majority of futures contracts "settle" in cash, where the buyer does not want the actual commodity but takes his profits in cash when the contract is about to expire. Speculators play the futures market much like they do the stock market-in hopes to make a profit. They have no connection to any company that needs any actual commodity or produces any commodity, so they don't want someone dumping a huge amount of cocoa, sugar or coffee on their front doorsteps.
Now with PMs (as well as other commodities), the issue that comes into play is these futures markets can dictate the price you will pay for physical commodity at the grocery store or at the coin store. Even though a coin store will add a premium that may be higher or lower depending on the availability or lack thereof for the commodity in question, the base price of the PM is tied to the spot price that comes from a futures exchange. Thus the paper futures markets dictate what you pay at the coin store (at least for now).
It would seem that any institution(s) with enough money to play with can influence the direction of a commodity if they put enough $$$$$ into any particular direction (long or short) and overwhelm the other side of the transaction. The only way to counter that is for buyers to demand delivery so that the short (seller) has to come up with the physical commodity to deliver. If the actual underlying commodity is scarce, the seller may have a hard time coming up with it and will have to pay a higher price (than the paper price) to get the underlying commodity to deliver.
What makes things "interesting" is that a short (seller) can sell a commodity futures contract and is not required to have the physical on hand at the time they sell the contract (this is what I was told--if this is incorrect please someone let me know
). They have to keep their margin account with the proper amount just like the long (buyer) does, but don't have to have the entire amount of the underlying commodity in their possession ready to deliver when the contract is formed. In my opinion, this is akin to what is called naked short selling. If a person shorts a stock, they generally need to "borrow" the shares before they can short them. But if a commodities short (seller) can sell a contract and does not have to worry about getting a hold of the physical commodity underlying the contract UNLESS the buyer (long) decides he wants delivery when the contract is about to expire, the seller would have a huge advantage to influence prices. I believe that they have instituted position limits fairly recently to try to prevent "manipulation", but I don't know how all that works since I don't trade in futures.
One could opine that if a seller (short) were required to actually hold or have somehow in their possession the physical metal they are selling in the underlying contract at the time the contract is created, it would prevent the situation where lots of paper cash could disproportionately influence the price of the metal for reasons completely unrelated to the true supply and demand factors of said metal-such as mining output, industrial/investor demand, etc. But perhaps it gets back to the issue that if there is so much of the underlying commodity available and the sellers have no problem delivering when buyers demand delivery, then maybe the paper price (futures price) IS the right price for the commodity--for if the paper price were too low (as many say about silver for example), then wouldn't the short (seller) be unable to buy the physical metal for a price that makes it profitable to be a short in the first place when it comes time to deliver to the long (buyer)?
I wish I knew the answers to all of this. Just my opinions and random thoughts.
Jim
