Best gold trading strategies part 1 - Singapore Forex Trading, Singapore Forex Academy, Singapore Forex Association

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Best gold trading strategies part 1

Gold is priced mostly in U.S. Dollars, but until 1976, the value of the U.S. Dollar was based fully or partially upon the value of Gold: the U.S. Dollar was pegged to Gold. 

This means that Gold trading as we know it has only really been going since 1976. Many traders get emotional about Gold. 

It is a natural human emotion to get excited about this shiny and very expensive precious metal which we are used to seeing in expensive jewelry, but traders should view Gold just as a commodity like any other. 

Traders must think about the price fluctuations, not the asset itself, to make good trading decisions.

A good reason to trade Gold is that its price tends to fluctuate with greater volatility and force than traditional Forex currency pairs such as EUR/USD. 

For example, major currency pairs often fall or rise by only 8% or so over a year, while the price of Gold has sometimes risen by 100% within only a few months.  

Even though the cost of trading Gold in terms of spread and commission is proportionately greater than it is in Forex currency pairs, this bigger price movement still tends to make it more rewarding in terms of overall profit. 

 For example, the cost of trading EUR/USD is usually less than 0.01% of the position size, while the cost of trading spot Gold is typically nearly 0.02% - but who cares when the potential profit in trading Gold can be ten times what it will be in trading EUR/USD?

Trading Gold with Fundamental Analysis

Unlike stocks and shares, or a valuable commodity such as crude oil, Gold has very little intrinsic value as it has few practical uses. However, it is rare, and humans are attracted to it and have attributed value to it by consensus. 

It is impossible to measure minor fluctuations in that human perception from day to day, so in this sense, fundamental analysis is of limited value.

Another aspect of Gold which differentiates it from fiat currencies such as the U.S. Dollar is that its supply is limited. 

This should mean that a limited supply of Gold can be taken for granted. A problem with this analysis is that almost all the world’s known Gold is held by banks and governments, but nobody knows for sure exactly how much there is.  

It seems that the large banks, who have colluded for years to fix the price of Gold by means of a twice daily “Gold fix”, are able to manipulate perceptions of supply and demand.

Fortunately, a fundamental analysis of Gold can be applied through a macroeconomic analysis. For example, analysts traditionally see the value of Gold rising under the following circumstances:
  • High inflation
  • Economic crisis / instability
  • Falling U.S. Dollar
  • Negative real interest rates
Are these analysts correct? We can check the data since Gold’s fully free float began in 1976 to see whether the price of Gold correlates with these factors.

Correlation of Gold with U.S. Inflation

The U.S. has not seen historically high annual rates of inflation, defined as a rate greater than 6%, since the early 1980s. The U.S. suffered from high inflation during the late 1970s and early 1980s, and the price of Gold rose dramatically during this period. 

 There was a strong correlation between Gold and inflation over this time, but when inflation rose again during the late 1980s the price of Gold fell.

The bottom line is that the price of Gold may be likely to rise when inflation reaches an unusually high level, and there is a small positive correlation between the monthly change in the Gold price and the monthly U.S. inflation rate over the entire period from 1976 to 2019. 

The correlation coefficient between the two was 17.24%, with 100% indicating perfect correlation and 0% indicating no correlation at all. 

This means that it is probably wise to only expect Gold to rise strongly when inflation reaches an unusually high rate, but it is also reasonable to be more bullish on Gold when inflation is rising and more bearish when inflation in falling.
Gold / U.S. Inflation correlation chart
Gold / U.S. Inflation correlation chart

Correlation of Gold with Economic Crisis / Instability

Economic crisis or instability is difficult to measure objectively. However, there can be little doubt that a country entering a major economic crisis tends to see the relative value of its currency depreciate.

 Additionally, the worst economic crisis in the U.S.A. in recent decades occurred during the 1970s, and this was a period during which the price of Gold in U.S. Dollars increased dramatically.

It seems that the price of Gold did rise during a period of serious economic crisis in the U.S.A., but we do not have a lot of data for this case.

Correlation of Gold with the U.S. Dollar Index

As Gold is priced in U.S. Dollars, you would expect the price of Gold in Dollars to be very strongly positively correlated with the U.S. Dollar Index, which measures the fluctuation in the relative value of the U.S. Dollar against a volume-weighted basket of other currencies. 

A measurement of the correlation coefficient of all the monthly price changes in Gold and the U.S. Dollar Index from 1976 to 2019 shows a minor positive correlation of approximately 25.23%.

Considering we are measuring the price of Gold with the U.S. Dollar, this correlation is not very strong, but may have a use within technical analysis, which will be discussed later within this article.
Gold / U.S. Dollar Index correlation chart
Gold / U.S. Dollar Index correlation chart

Correlation of Gold with Negative Real Interest Rates

As Gold is believed by many to be a store of value with a finite supply, while fiat currencies can be debased or artificially inflated by the central banks and governments which control them, it can be argued that the price of Gold in a fiat currency such as the U.S.

 Dollar will be bound to rise when the fiat currency is being debased. Indicators for the debasement of a currency include high inflation, which we have already discussed, and negative real interest rates. 

A currency has a negative real interest rate when its inflation rate is higher than its interest rate, because the currency is depreciating in value by more than it pays in interest, so depositors of that currency make a net loss over time.

The problem we face here is that the U.S. Dollar has suffered a negative real interest rate only twice since 1976: during a very brief period in the late 1970s, and then again during 2018 and 2019. 

This means that we don’t have a long enough sample to make a statistically meaningful analysis of the correlation between Gold and a negative interest rate, but it is true that the price of Gold in U.S. Dollars broadly rose during these periods, so it would seem possible that there is a positive correlation.

The correlation between the price of Gold and the U.S. interest rate could also be examined, but as the interest rate tends to be highly correlated with the inflation rate, we effectively already covered it.

Trading Gold with Seasonality

“Seasonality” is a form of fundamental analysis which is based upon a theory that demand for an asset such as Gold tends to peak or ebb with the seasons of the year. 

For example, the price of natural gas would tend to rise during the winter in the northern hemisphere as cold weather brings more demand. 

It is hard to see the same logic applying to Gold, but the table below shows that there have been certain months of the year where the price of Gold has tended to either outperform or underperform its average. 

I do not believe the concept of seasonality applies well to trading Gold, but I present the data anyway. From 2001 to 2019, the price of Gold rose in 56% of months. 

The percentages of calendar months during this period when Gold rose are shown below:

Gold Seasonality
Gold Seasonality

The data suggest that August and September have been especially good months for buying Gold while February and July have been good months for selling Gold.

Track Industrial, Commercial Demand for Gold

Increased market demand for gold can affect prices due to the fixed global supply of the material. 

Demand can come in multiple forms. Certain industries may increase their acquisitions of gold due to the material’s role in consumer projects. 

Both the medical and tech industries, for example, use gold in certain products and solutions.

Consumer demand for gold jewelry can also affect prices. 

Consider global demand in foreign markets where gold jewelry is considered both a luxury good and an investment asset.

Pay Attention to Changes in Gold Production

In the past few years, gold mining hasn’t seen any dramatic shifts. 

It’s not necessarily related to a stagnant demand for gold: Although gold is in demand and has seen overall mining production increase over the past decade, today’s gold mining efforts face higher costs due to the challenges of accessing underground gold reserves in hard-to-reach places.

The most accessible gold reserves—at least the ones currently known—have already been mined and placed into the global supply. 

The remaining gold reserves represent much more expensive mining operations, which decreases profit potential for mining businesses. 

But limited production isn’t a sign that gold is poised for a decline. 

In fact, the opposite is true: Stable gold production could put the squeeze on global demand and lead to higher prices, especially if central banks and other common buyers of gold start seeking out this asset.

Understand the relationship between gold and geopolitics

Much like when investors are wary over the forex or stock markets, the price of gold often benefits at times of geopolitical uncertainty.
The $1920 peak price for an ounce of gold in 2011 was not only in the wake of the financial crisis but coincided with heightened tensions within the international community, with the Arab Spring revolutions in the Middle East and the tumult in Greece as a result of austerity measures introduced by the European Union (EU) after the country’s economic collapse. 

More recently, gold was a favoured option for investors when tensions between the US and nuclear-bearing North Korea began to ramp-up, before subsiding into diplomatic talks.

Monitor Central Bank Buying

Central banks tend to buy gold as a hedge when they’re anticipating volatility in certain currencies. 

Recently, for example, China and Russia made headlines for significant investments in gold, which reflected their concern about the future price of the U.S. dollar and the euro, among other major global currencies.

When central banks start buying gold in large amounts, it tells forex traders two things. 

First, governments are operating out of a belief that major currency values may dip, which could encourage traders to move a greater percentage of their investments into less volatile funds.

Second, increased central bank buying typically causes an increase in the price of gold—at least in the short term. If gold prices start trending up, it could be an opportunity to turn a quick profit.

The precious metal has historically shown a tendency to rise in price during periods of unusually high inflation, severe economic crisis, or negative real interest rates. 

Over the long term, Gold has not shown any meaningful positive or negative correlation with stock markets.

On a more micro level, it is often true that when markets are in “risk off” mode, money tends to flow into the Japanese Yen, Swiss Franc, and Gold. Therefore, Gold traders can learn to spot “risk off” sentiment and look to enter long Gold trades at these times.