A common misconception among gold buyers is that gold dealers make money when the price of gold increases, and subsequently lose money when the price of gold decreases. Generally speaking, nothing could be further from the truth. Gold dealers are highly risk averse given the volatility of the metals market, and so they are very unlikely to speculate on future spot price. (Review: Spot price is the over-the-counter commodities exchange price for a 400 oz good delivery gold bar. It is the price quoted on new stations as the “gold price“.)
So do gold dealers protect themselves against price fluctuations?
Well, there a two types of gold dealer: those that stock inventory and ship “in-house,” and those that broker sales and drop-ship from larger wholesalers. Some operate hybrid operations, stocking some products, and drop shipping others.
For the dealers holding inventory, almost all “hedge” their inventory in the markets. If buying gold is the same as taking a “long” position, then by “shorting” gold in the market (e.g. betting the price will decrease) dealers are protected regardless which direction the gold price moves. For example, if the gold price increases $50, the dealer will make an additional $50 on the sale to the customer, while at the same time losing $50 on his short position. Conversely, if the price decreases $50, the dealer will lose money on the sale to the customer, but make it back on his short position.
Gold brokers are unaffected by the spot price at all, because the spot price they charge to the customer is roughly identical to the spot price they buy from the wholesaler. In this way, they essentially pass along hedging responsibility to the wholesaler, while making money on the premium.
In either case, the system is not fool proof. Since the vast majority of dealers “lock-in” the customer to a price before the customer pays, dealers who have unhedged their position, and brokers who have locked in with wholesalers, are exposed to price fluctuations in the event that the customer decides not to pay. Unfortunately, many investors think buying bullion is no different than buying a book online; that the vendor is in no way impacted for an order cancellation. On the contrary, a non-paying customer poses a serious problem for dealers. A “simple” order cancellation might cost a dealer thousands of dollars.
So how do gold dealers make money?
Dealers make their money on the “premium,” the amount charged over the spot price. For a US Mint Gold Eagle, you may pay a premium of $60 above the spot price of gold. But before you assume that a gold dealer makes $60 per coin, you must also consider that dealers do not buy these coins at the spot price either.
It costs money to melt, refine, and mint gold into a beautiful gold coin, so institutions like the United States Mint charge a 3% premium for Gold Eagles to their authorized wholesalers, of which there are only about a dozen. The 4,000+ dealers throughout the United States must then purchase these Gold Eagles from these distributors at a premium. Therefore, the gold coin you purchase from a dealer may actually cost the dealer $40-$45 over the spot price.
As strange as it may seem, for a purchase of ten gold coins with a dollar value of $14,500, a gold dealer may profit only $100-$150, or right around 1%.