A Brief History of Gold Trading
During the mid-1970s, the Bretton Woods agreement established the financial and commercial relations between major industrial countries. The countries that participated agreed they would allow their currencies to float in a marketplace.
The agreement removed gold as the standard as to which countries would benchmark their currencies. The float of currencies somewhat reduced the need for countries to hold large gold reserves and brought on the importance of new reserve currency – the US dollar.
Reasons to Trade Gold
Gold is a commodity that has been a hard asset benchmark throughout human history. The yellow metal is sought after for jewelry, as well, as a way to build wealth. Gold is often viewed as a currency and when you trade it for future delivery the price incorporates a gold interest rate called the gold forward rate (GOFO).
Gold is held in reserve by most countries throughout the globe. Until the mid-1970's gold was used as the benchmark for a fixed rate exchange mechanism on currencies including the US dollar. This was the case until a global agreement changed currency trading to a floating rate mechanism. Gold used to be difficult to transact, but recent developments within the capital markets have made gold trading easy and liquid.
Gold is viewed as a hard asset that can be used as a hedge against future inflation expectations. This compares to assets like bonds and stocks which provide payments from a loan or a share of future profits. Gold prices generally rise along with inflation. As a hard asset, the demand for gold increases to protect investors against the decline in the value of their currency.
Risks Associated with Trading Gold
Gold, like any asset, has risks. Whether you buy or sell gold, you are risking capital and could experience an adverse market change. Gold can fluctuate if there are geopolitical events that drive investors to the safety of gold. If a mining company cannot produce the volume of gold expected, demand might exceed supply driving the price of gold higher. Additionally, financial stress can generate strong demand for gold. During the financial crisis that commenced in early 2008 and until late 2012, the price of gold increased by more than 230%.
How to Trade Gold
Gold is traded in number of ways, including:
- Physical trading (gold bar, coin, or bullion)
- Futures Contracts
Most of the gold that is transacted globally trades in the over the counter market. This type of trade generally occurs between two banks, banks and their clients or banks and central banks. The trades are generally customized for delivery at a specific date in the future.
The most common transactions are spot trades which means that delivery is two days after the transaction. Gold can also be transacted in the forward market which is delivery beyond 2 days. In this case, a gold interest rate is used to determine the future price of gold. The gold forward rate is added to the spot rate to attain a gold forward price.
Many traders like to trade physical gold. This involves the exchange of cash for physical bullion, bars, or coins. If you plan to engage in this activity, you need to know exactly what you are buying. Most of the physical gold that is traded is 99.99% pure. This process works for investors who are looking to hold a tangible item at home or in a vault. Physical gold is relatively easy to buy through coin shops, but the liquidity is only fair, and it is difficult for an investor to receive transparent pricing.
ETFs, CFDs and Futures Contracts
These products emulate the price of over the counter gold prices and the liquidity is excellent. For investors that are active in the futures markets, gold can be traded through exchanges such as the Chicago Mercantile Exchange. These exchanges require a futures account at a broker that is an active clearing member.
Contracts for Differences
A contract for difference is a security that tracks the movements of another asset. For example, a contract for difference on gold bullion tracks gold prices. If gold increases by 2%, a gold CFD will also increase by 2%. The benefits of trading a gold CFD is that you are only responsible for the difference in the price of the CFD, from the time you purchase it to the time you sell it or vice versa. You never have to own physical gold or take delivery.
There are several benefits to trading contracts for differences, including leverage. CFD brokers provide leverage through a margin account which allows you to increase the returns that you receive on the money that you are expected to post for each trade.
CFDs provide leverage that can enhance your returns and allow you to trade instruments for pennies on the dollar. For example, with gold trading near $1,700 per ounce, a CFD broker might allow you to purchase 1-ounce of gold for as little at $17 using 100-1 leverage.
Gold Futures Contracts
An alternative to CFDs is gold futures contracts. The gold futures contract listed on the Chicago Mercantile Exchange is physically delivered. This means if you hold the contract beyond the delivery date you are required to take delivery of gold in a CME regulated warehouse.
Most of the gold that is traded on the CME is not taken to delivery. Most traders, exit or roll their position and never take physical delivery. The CME also offers a gold e-mini contract that is financially settled.
One of the benefits of trading futures contracts is that the futures exchanges provide margin to customers. This means that you can borrow money to leverage your position and enjoy enhanced returns.
As of April 2020, the leverage on gold is approximately 18:1. This means for every $1 you post you can borrow $18 to trade. This number will fluctuate based on the volatility in the gold market. Presently the CME requires that you post $9,150 for each futures contract you trade. This compares to the $170,000 value you would hold from owning a futures contract (100 ounces * $1,700 per contract-current price as of April 2020).
Leveraged Futures Contracts Returns are Robust
The CME has the right to change the leverage it will offer at any time. Changes are generally based on gold volatility. The higher the volatility the higher the initial margin which equates to lower levels of leverage. Futures contracts are also very liquid, allowing you to enter and exit positions seamlessly. The downside of trading futures is elevated costs. You will need at least $9,150 to post the initial margin needed to buy one contract.
Gold Trading Strategies
There are several trading strategies that you can use to trade gold:
- Evaluating sentiment
- Technical indicators
- Trend following
- Fundamental analysis
You can use an active trading strategy or a passive buy and hold strategy. Many financial analysts will recommend that you passively own gold as a certain percentage of your portfolio. You can use several different types of technical strategies, along with evaluating exchange information to determine sentiment.
One of the best ways to determine if other trades are betting on gold is to evaluate the commitment of traders’ report, released every Friday by the Commodity Futures Trading Commission. This report will provide you with information about investor sentiment. The report shows any increases or decreases in gold futures and options contracts held by swap dealers, hedge funds, or retail traders.
Swap dealers represent producer positions, as banks generally offset their OTC swap positions with futures contracts. Managed money represents hedge funds traders. Since hedge funds are speculating, the information provided can be especially useful.
For example, the commitment of traders report shows that hedge funds reduced long positions in gold futures and options as of the date ending April 21, 2020 (red circle). The decline in long positions shows that some hedge funds are taking profits on gold.
The open interest of 187K contracts relative to the short opening interest of 7.6K contracts tells you that hedge funds are well overweight gold and if there was an adverse move lower, there would likely be a rush toward the door. The decline of 17K contracts on the latest week means that more than 204K contracts were open the previous week as hedge funds bet that gold prices go higher.
The increase in short positions (the red circle which shows an increase of 1.6K contracts) tells you that some hedge funds are betting that gold prices will decline. This report can be used as a contrarian sentiment indicator.
In addition to using sentiment analysis, you might also consider using technical analysis to trade gold actively. You can also use a gold trading chart to check the current prices and see where prices were in the past. This might help you determine the future direction of gold prices. A chart will help you determine both support and resistance levels, trends, as well as momentum. You can even determine if the recent move in the price is overextended.
Technical indicators can help you determine where prices might find support, which is levels where prices cannot penetrate lower, or resistance, where prices cannot pierce higher. For example, the 10-day moving average on the chart is likely a support level.
You can also use moving averages to determine a trend. A moving average is the average of a specific period. You can use any period, to create an average. When a 10-day moving average, crosses a longer-term moving average, like the 50-day moving average (depicted on the chart), a short-term uptrend is considered in place. You can use the same moving averages to find a short-term downtrend.
An indicator like the moving average convergence divergence index describes momentum. This indicator subtracts a short-term momentum average from a longer-term moving average and compares that change in the moving average to a moving average of that change. When a MACD crossover occurs (as it does in the chart of gold prices) momentum is turning positive.
Momentum oscillators such as the fast stochastic can tell you when prices are overextended. When the fast-stochastic prints a reading above 80, the price of gold is considered overbought and points to a potential correction. When the fast-stochastic prints a level below 20, the price of gold is considered oversold and could rebound.
The most common form of fundamental analysis related to gold is evaluating the value of the US dollar. Since gold is priced in US dollars it generally increases when the dollar declines and falls when the dollar is rising. This is because gold prices become more expensive in currencies other than the US dollar when the value of the US dollar climbs. To compensate for this change in value, the price of gold needs to decline.
Gold is the most liquid precious metal and is traded throughout the globe. There are several ways to buy and sell gold including using physical coins and bars, as well as purchasing and selling contracts for differences (CFDs). Additionally, you can buy and sell exchange-traded funds (ETFs) and futures contracts.
You can also use many different gold trading strategies including using sentiment and technical analysis along with a buy and hold strategy. Since gold is viewed as a hard asset, higher levels of inflation will generally increase its value. Gold is also viewed as a safe-haven asset. During periods of financial stress or geopolitical unrest, investors tend to purchase gold to protect themselves from adverse market conditions.
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