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By Julian D W Phillips

The visible danger of financial derivatives have been well documented, writes Julian Philips of Gold Forecaster, as the risk of their collapse has the same potential as the sub prime crisis to create havoc worldwide.

But for Gold and silver investors, the long term upward drive in commodity prices should limit the threat to a process of de leveraging, as we have already seen in the large lowering of net speculative long gold positions on COMEX, the US commodity futures exchange.

Here we are going to highlight a potentially more destructive facet of derivatives: the threat of government interference in open markets as a result of so called speculative excess .

Gold, Derivatives Risk

Simply put, a derivative is a paper instrument founded on an asset. Its value is derived from that underlying asset, and it can be a purchase or sale of a commodity in the future it can be a share in a trust based structure such as an Exchange Traded Fund (ETF) or it can be an option or one of many other similar instruments.

The classic use of a derivative is to smooth out price volatility for commodity producers. When a silver or gold user say, a large bullion wholesaler found they had to buy or sell metal, they would usually buy ahead of the date of their need. That would ensure its availability on that date.

But this protection left them exposed to the Gold Price. The danger was of paying too much or selling for too little. How could they remove this risk? They had to hedge their future sale. But how?

If delivery of gold sold (or bought) were to take place, say, in a year's time, they would sell (or buy) that position in the futures market or take out a put or call option (the right to sell or buy at a certain price at that future date).

This left them both a long position and a short position on gold, netting out at a neutral position on the metal.

If the Gold Market then moved substantially either way, far outside its expected price levels, they could protect themselves fairly easily. How? If the price were to go down they could then close the short position by buying the same quantity at the lower price to close out at the same date as the put option. This would leave them net long at the lower price.