Learn How To Trade Gold In 4 Steps (GLD, GDX) By Alan Farley
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Whether bull or bear, the gold market offers high liquidity and excellent opportunities to profit in nearly all market environments due to its unique position within the world’s economic and political systems. While many folks choose to own the metal outright, speculating through the futures, equity and options markets offers incredible leverage with measured risk. (See related: Gold Price: Catching Resistance off of the 2015 Trend-Line.)
Market participants often fail to take full advantage of gold price fluctuations because they haven’t learned the unique characteristics of world gold markets or the hidden pitfalls that can rob profits. In addition, not all investment vehicles are created equally, with some gold venues more likely to produce consistent results while others frustrate most attempts to profit.
Trading the yellow metal isn’t hard to learn, but the activity requires skill sets unique to these markets. While broad-based experience assists bottom line results, seasoned professionals will benefit by incorporating four strategic steps into their daily routines. Meanwhile, novices should tread lightly, experimenting until the intricacies of these complex markets become second-hand.
1. Learn What Moves Gold
As one of the oldest currencies on the planet, gold has embedded itself deeply into the psyche of the financial world. Nearly everyone has an opinion about the yellow metal, whether or not they’re taking risk, but gold itself reacts only to a limited number of price catalysts. Each of these forces splits down the middle in a polarity that impacts sentiment, volume and trend intensity:
Inflation and deflation
Greed and fear
Supply and demand
Market players face elevated risk when they trade gold in reaction to one polarity when another polarity is controlling price action. For example, a selloff hits world financial markets, and gold takes off in a strong rally. Many traders assume that fear is moving the yellow metal and jump in, believing the emotional crowd will blindly carry price higher. However, inflation fears may have triggered the decline, attracting a more technical crowd that will sell the rally aggressively.
Combinations of these forces are always in play in world markets, establishing long-term themes that track equally long uptrends and downtrends. For example, the Federal Reserve (FOMC) economic stimulus begun in 2009 initially had little effect on gold because market players were focused on high fear levels coming out of the 2008 economic collapse. However, this quantitative easing encouraged deflation, setting up the gold market and other commodity groups for a major reversal.
That turnaround didn’t happen immediately because a reflation bid was underway, with depressed financial and commodity-based assets spiraling back toward historical means. Gold finally topped out and turned lower in 2011 after reflation was completed and central banks intensified their quantitative easing policies. VIX eased to lower levels at the same time, signaling that fear was no longer a significant market mover.
2. Understand the Crowd
Gold attracts numerous crowds with diverse and often opposing interests. Gold bugs stand at the top of the heap, collecting physical gold and allocating an outsized portion of family assets to gold equities, options and futures. These are long-term players rarely dissuaded by downtrends that shake out less ideological players. In addition, retail participants comprise nearly the entire population of gold bugs, with few funds devoted entirely to the long side of the precious metal.
Gold bugs add enormous liquidity while keeping a floor under futures and gold stocks because they provide a continuous supply of buying interest at lower prices. They also serve the contrary purpose of providing efficient entry for short sellers, especially in emotional markets when one of the three primary forces polarizes in favor of strong buying pressure.
In addition, gold attracts enormous hedging activity by institutions, who buy and sell in combination with currencies and bonds in bilateral strategies known as “risk-on” and risk-off.” Funds create baskets of instruments matching growth (risk-on) and safety (risk-off), trading these combinations through lightning fast algorithms. They are especially popular in highly conflicted markets in which public participation is lower than normal.
3. Read the Long-Term Chart
Gold Monthly Chart
Take time to learn the gold chart inside and out, starting with long-term history that goes back at least 100 years. In addition to carving out trends that persisted for decades, the metal has also trickled lower for incredibly long periods, denying profits to gold bugs. From a strategic standpoint, this analysis identifies price levels that need to be watched if and when the yellow metal returns to test them.
Gold’s recent history shows little movement until the 1970s, when it took off in a long uptrend, underpinned by rising inflation due to skyrocketing crude oil prices. It turned lower near 700 in the early 1980s, in reaction to restrictive Federal Reserve monetary policy. The subsequent downtrend lasted into late 1990s when gold entered the historic uptrend that culminated in the 2011 top. A steady decline since that time has relinquished more than 700 points in 4 years.
4. Choose Your Venue
Liquidity follows gold trends, increasing when it’s moving sharply higher or lower and decreasing during relatively quiet periods. This oscillation impacts the futures markets to a greater degree than it does equity markets, due to much lower average participation rates. New products offered by Chicago’s CME Group in recent years haven’t improved this equation substantially.
CME offers three primary gold futures, the 100-oz contract, a 50-oz. mini contract and a 10-oz micro contract added in September 2011. While the largest contract traded close to 200K lots per day in 2015, the smaller contracts were not widely traded, averaging less than 500 lots per day for the mini and less than 2500 for the micro. This thin participation doesn’t impact long-dated futures held for months but strongly impacts trade execution in short-term positions, forcing higher costs through slippage.
SPDR Gold Shares (GLD) shows the greatest participation in all types of market environments, with exceptionally tight spreads that can drop to one penny. Average daily volume stood at 5.39 million shares per day in September 2015, offering easy access at any time of day. CBOE options on GLD offer another liquid alternative, with active participation keeping spreads at low levels.
Market Vectors Gold Miners ETF (GDX) grinds through greater daily percentage movement than GLD but carries higher risk because correlation with the yellow metal can vary greatly from day to day. Large mining companies hedge aggressively against price fluctuations, lowering the impact of spot and futures prices, while operations may hold significant assets in other natural resources, including silver and iron.
The Bottom Line
Trade the gold market profitably in four steps. First, learn how three polarities impact the majority of gold buying and selling decisions. Second, familiarize yourself with the diverse crowds that focus on gold trading, hedging and ownership. Third, take time to analyze the long and short-term gold charts, with an eye on key price levels that may come into play. Finally, choose your venue for risk taking, focused on high liquidity and easy trade execution. (See also: The Effect of Fed Fund Rate Hikes on Gold.)
While popular opinion is that interest rate hikes have a bearish effect on gold prices, the effect that an interest rate increase has on gold, if any, is unknown, since there is actually little solid correlation between interest rates and gold prices. Rising interest rates may even have a bullish effect on gold prices.
Popular Belief About Interest Rates and Gold
As the Federal Reserve considers raising interest rates for the first time in several years, many investors believe that higher and rising interest rates will pressure gold prices downward. Many investors and market analysts believe that, as rising interest rates make bonds and other fixed income investments more attractive, money will flow into higher-yielding investments, such as bonds and money market funds, and out of gold, which offers no yield at all.
The Historical Truth
Despite widespread popular belief of a strong negative correlation between interest rates and the price of gold, a long-term review of the respective paths and trends of interest rates and gold prices reveals that no such relationship actually exists. The correlation between interest rates and the price of gold over the past half century, from 1970 to 2015, has only been about 28%, which is considered to be not much of a significant correlation at all.
A study of the massive bull market in gold that occurred during the 1970s reveals that gold's run-up to its all-time high price of the 20th century happened right when interest rates were high and rapidly rising. Short-term interest rates, as reflected by one-year Treasury bills (T-bills), bottomed out at 3.5% in 1971. By 1980, that same interest rate had more than quadrupled, rising as high as 16%. Over that same time span, the price of gold mushroomed from $50 an ounce to a previously unimaginable price of $850 an ounce. Overall during that time period, gold prices actually had a strong positive correlation with interest rates, rising right in concert with them.
A more detailed examination only supports the at least temporary positive correlation during that time period further. Gold made the initial part of its steep move up in 1973 and 1974, a time when the federal funds rate was rising quickly. Gold prices fell off a bit in 1975 and 1976, right along with falling interest rates, only to begin soaring higher again in 1978 when interest rates began another sharp climb upward.
The protracted bear market in gold that followed, beginning in the 1980s, occurred during a time span when interest rates were steadily declining.
During the most recent bull market in gold in the 2000s, interest rates declined significantly overall as gold prices rose. However, there is still little evidence of a direct, sustained correlation between rising rates and falling gold prices or declining rates and rising gold prices, because gold prices peaked well in advance of the most severe decline in interest rates. While interest rates have been kept pressed to nearly zero, the price of gold has corrected downward. By the conventional market theory on gold and interest rates, gold prices should have continued to soar since the 2008 financial crisis. Also, even when the federal funds rate climbed from 1 to 5% between 2004 and 2006, gold continued to advance, increasing in value an impressive 49%.
What Really Drives Gold Prices
The price of gold is ultimately not a function of interest rates. Like most basic commodities, it is a function of supply and demand in the long run. Between the two, demand is the stronger component. The level of gold supply only changes slowly, since it takes 10 years or more for a discovered gold deposit to be converted into a producing mine. Rising and higher interest rates may in fact be bullish for gold prices, simply because they are typically bearish for stocks.
It is the stock market rather than the gold market that typically suffers the largest outflow of investment capital when rising interest rates make fixed income investments more attractive. Rising interest rates nearly always lead investors to rebalance their investment portfolios more in favor of bonds and less in favor of stocks. Higher bond yields also tend to make investors less willing to buy into stocks that may have significantly overvalued multiples. Higher interest rates mean increased financing expenses for companies, an expense that usually has a direct negative impact on net profit margins. That fact only makes it more likely that rising rates will result in devaluations of stocks.
With stock indexes at or near all-time highs, the stock market is definitely vulnerable to a significant downside correction. Whenever the stock market declines significantly, one of the first alternative investments that investors consider transferring money into is gold. Gold prices increased by more than 150% during 1973 and 1974, at a time when interest rates were rising and the S&P 500 Index dropped by more than 40%.
Given the historical tendencies of the actual reactions of stock market prices and gold prices to interest rate increases, the likelihood is greater that stock prices will be negatively impacted by rising interest rates and that gold may in fact benefit as an alternative investment to equities.
SHARE TWEET
Whether bull or bear, the gold market offers high liquidity and excellent opportunities to profit in nearly all market environments due to its unique position within the world’s economic and political systems. While many folks choose to own the metal outright, speculating through the futures, equity and options markets offers incredible leverage with measured risk. (See related: Gold Price: Catching Resistance off of the 2015 Trend-Line.)
Market participants often fail to take full advantage of gold price fluctuations because they haven’t learned the unique characteristics of world gold markets or the hidden pitfalls that can rob profits. In addition, not all investment vehicles are created equally, with some gold venues more likely to produce consistent results while others frustrate most attempts to profit.
Trading the yellow metal isn’t hard to learn, but the activity requires skill sets unique to these markets. While broad-based experience assists bottom line results, seasoned professionals will benefit by incorporating four strategic steps into their daily routines. Meanwhile, novices should tread lightly, experimenting until the intricacies of these complex markets become second-hand.
1. Learn What Moves Gold
As one of the oldest currencies on the planet, gold has embedded itself deeply into the psyche of the financial world. Nearly everyone has an opinion about the yellow metal, whether or not they’re taking risk, but gold itself reacts only to a limited number of price catalysts. Each of these forces splits down the middle in a polarity that impacts sentiment, volume and trend intensity:
Inflation and deflation
Greed and fear
Supply and demand
Market players face elevated risk when they trade gold in reaction to one polarity when another polarity is controlling price action. For example, a selloff hits world financial markets, and gold takes off in a strong rally. Many traders assume that fear is moving the yellow metal and jump in, believing the emotional crowd will blindly carry price higher. However, inflation fears may have triggered the decline, attracting a more technical crowd that will sell the rally aggressively.
Combinations of these forces are always in play in world markets, establishing long-term themes that track equally long uptrends and downtrends. For example, the Federal Reserve (FOMC) economic stimulus begun in 2009 initially had little effect on gold because market players were focused on high fear levels coming out of the 2008 economic collapse. However, this quantitative easing encouraged deflation, setting up the gold market and other commodity groups for a major reversal.
That turnaround didn’t happen immediately because a reflation bid was underway, with depressed financial and commodity-based assets spiraling back toward historical means. Gold finally topped out and turned lower in 2011 after reflation was completed and central banks intensified their quantitative easing policies. VIX eased to lower levels at the same time, signaling that fear was no longer a significant market mover.
2. Understand the Crowd
Gold attracts numerous crowds with diverse and often opposing interests. Gold bugs stand at the top of the heap, collecting physical gold and allocating an outsized portion of family assets to gold equities, options and futures. These are long-term players rarely dissuaded by downtrends that shake out less ideological players. In addition, retail participants comprise nearly the entire population of gold bugs, with few funds devoted entirely to the long side of the precious metal.
Gold bugs add enormous liquidity while keeping a floor under futures and gold stocks because they provide a continuous supply of buying interest at lower prices. They also serve the contrary purpose of providing efficient entry for short sellers, especially in emotional markets when one of the three primary forces polarizes in favor of strong buying pressure.
In addition, gold attracts enormous hedging activity by institutions, who buy and sell in combination with currencies and bonds in bilateral strategies known as “risk-on” and risk-off.” Funds create baskets of instruments matching growth (risk-on) and safety (risk-off), trading these combinations through lightning fast algorithms. They are especially popular in highly conflicted markets in which public participation is lower than normal.
3. Read the Long-Term Chart
Gold Monthly Chart
Take time to learn the gold chart inside and out, starting with long-term history that goes back at least 100 years. In addition to carving out trends that persisted for decades, the metal has also trickled lower for incredibly long periods, denying profits to gold bugs. From a strategic standpoint, this analysis identifies price levels that need to be watched if and when the yellow metal returns to test them.
Gold’s recent history shows little movement until the 1970s, when it took off in a long uptrend, underpinned by rising inflation due to skyrocketing crude oil prices. It turned lower near 700 in the early 1980s, in reaction to restrictive Federal Reserve monetary policy. The subsequent downtrend lasted into late 1990s when gold entered the historic uptrend that culminated in the 2011 top. A steady decline since that time has relinquished more than 700 points in 4 years.
4. Choose Your Venue
Liquidity follows gold trends, increasing when it’s moving sharply higher or lower and decreasing during relatively quiet periods. This oscillation impacts the futures markets to a greater degree than it does equity markets, due to much lower average participation rates. New products offered by Chicago’s CME Group in recent years haven’t improved this equation substantially.
CME offers three primary gold futures, the 100-oz contract, a 50-oz. mini contract and a 10-oz micro contract added in September 2011. While the largest contract traded close to 200K lots per day in 2015, the smaller contracts were not widely traded, averaging less than 500 lots per day for the mini and less than 2500 for the micro. This thin participation doesn’t impact long-dated futures held for months but strongly impacts trade execution in short-term positions, forcing higher costs through slippage.
SPDR Gold Shares (GLD) shows the greatest participation in all types of market environments, with exceptionally tight spreads that can drop to one penny. Average daily volume stood at 5.39 million shares per day in September 2015, offering easy access at any time of day. CBOE options on GLD offer another liquid alternative, with active participation keeping spreads at low levels.
Market Vectors Gold Miners ETF (GDX) grinds through greater daily percentage movement than GLD but carries higher risk because correlation with the yellow metal can vary greatly from day to day. Large mining companies hedge aggressively against price fluctuations, lowering the impact of spot and futures prices, while operations may hold significant assets in other natural resources, including silver and iron.
The Bottom Line
Trade the gold market profitably in four steps. First, learn how three polarities impact the majority of gold buying and selling decisions. Second, familiarize yourself with the diverse crowds that focus on gold trading, hedging and ownership. Third, take time to analyze the long and short-term gold charts, with an eye on key price levels that may come into play. Finally, choose your venue for risk taking, focused on high liquidity and easy trade execution. (See also: The Effect of Fed Fund Rate Hikes on Gold.)
While popular opinion is that interest rate hikes have a bearish effect on gold prices, the effect that an interest rate increase has on gold, if any, is unknown, since there is actually little solid correlation between interest rates and gold prices. Rising interest rates may even have a bullish effect on gold prices.
Popular Belief About Interest Rates and Gold
As the Federal Reserve considers raising interest rates for the first time in several years, many investors believe that higher and rising interest rates will pressure gold prices downward. Many investors and market analysts believe that, as rising interest rates make bonds and other fixed income investments more attractive, money will flow into higher-yielding investments, such as bonds and money market funds, and out of gold, which offers no yield at all.
The Historical Truth
Despite widespread popular belief of a strong negative correlation between interest rates and the price of gold, a long-term review of the respective paths and trends of interest rates and gold prices reveals that no such relationship actually exists. The correlation between interest rates and the price of gold over the past half century, from 1970 to 2015, has only been about 28%, which is considered to be not much of a significant correlation at all.
A study of the massive bull market in gold that occurred during the 1970s reveals that gold's run-up to its all-time high price of the 20th century happened right when interest rates were high and rapidly rising. Short-term interest rates, as reflected by one-year Treasury bills (T-bills), bottomed out at 3.5% in 1971. By 1980, that same interest rate had more than quadrupled, rising as high as 16%. Over that same time span, the price of gold mushroomed from $50 an ounce to a previously unimaginable price of $850 an ounce. Overall during that time period, gold prices actually had a strong positive correlation with interest rates, rising right in concert with them.
A more detailed examination only supports the at least temporary positive correlation during that time period further. Gold made the initial part of its steep move up in 1973 and 1974, a time when the federal funds rate was rising quickly. Gold prices fell off a bit in 1975 and 1976, right along with falling interest rates, only to begin soaring higher again in 1978 when interest rates began another sharp climb upward.
The protracted bear market in gold that followed, beginning in the 1980s, occurred during a time span when interest rates were steadily declining.
During the most recent bull market in gold in the 2000s, interest rates declined significantly overall as gold prices rose. However, there is still little evidence of a direct, sustained correlation between rising rates and falling gold prices or declining rates and rising gold prices, because gold prices peaked well in advance of the most severe decline in interest rates. While interest rates have been kept pressed to nearly zero, the price of gold has corrected downward. By the conventional market theory on gold and interest rates, gold prices should have continued to soar since the 2008 financial crisis. Also, even when the federal funds rate climbed from 1 to 5% between 2004 and 2006, gold continued to advance, increasing in value an impressive 49%.
What Really Drives Gold Prices
The price of gold is ultimately not a function of interest rates. Like most basic commodities, it is a function of supply and demand in the long run. Between the two, demand is the stronger component. The level of gold supply only changes slowly, since it takes 10 years or more for a discovered gold deposit to be converted into a producing mine. Rising and higher interest rates may in fact be bullish for gold prices, simply because they are typically bearish for stocks.
It is the stock market rather than the gold market that typically suffers the largest outflow of investment capital when rising interest rates make fixed income investments more attractive. Rising interest rates nearly always lead investors to rebalance their investment portfolios more in favor of bonds and less in favor of stocks. Higher bond yields also tend to make investors less willing to buy into stocks that may have significantly overvalued multiples. Higher interest rates mean increased financing expenses for companies, an expense that usually has a direct negative impact on net profit margins. That fact only makes it more likely that rising rates will result in devaluations of stocks.
With stock indexes at or near all-time highs, the stock market is definitely vulnerable to a significant downside correction. Whenever the stock market declines significantly, one of the first alternative investments that investors consider transferring money into is gold. Gold prices increased by more than 150% during 1973 and 1974, at a time when interest rates were rising and the S&P 500 Index dropped by more than 40%.
Given the historical tendencies of the actual reactions of stock market prices and gold prices to interest rate increases, the likelihood is greater that stock prices will be negatively impacted by rising interest rates and that gold may in fact benefit as an alternative investment to equities.
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