Before you begin to trade gold, you should understand several concepts that drive the movements of the yellow metal. Gold is considered one of the most widely traded commodities, but it is also considered a currency. Gold has widely been used as a currency and was a reserve currency until a few decades ago. Gold has a forward curve similar to a currency market and is commonly quoted in U.S. dollars. Gold and be traded in several ways. You can trade gold as a physical commodity and store it in your home or vault. You can also trade gold in the over-the-counter market through futures contracts, Contracts for Differences, and ETS. There are also a plethora of trading strategies that you can use to trade gold. Here are the five concepts you should understand before you start trading gold.
Gold has played an essential role as a currency. Gold coins were first introduced by King Croesus in Turkey around 550 BC. Gold trading was part of commerce well before paper money was raised. Gold, throughout its history, was a component of the monetary system. By the latter portion of the 19th century, many of the world’s major currencies were fixed to gold prices under the “Gold Standard“.
In June 1933, the United States moved away from the Gold Standard. The United States Congress enacted a resolution that muted creditors’ rights to demand gold instead of receiving U.S. dollars. President Roosevelt ordered all gold coins and certificates in denominates above $100 to be turned in for other currencies.
In 1973, the dollar started to float in the open market. Before this period, the dollar was a fixed exchange rate based on the price of gold. In the years to follow, currencies throughout the globe started to use the U.S. dollar as a reserve currency instead of gold. A free-floating exchange rate is determined by market participants based on the supply and demand for money.
The Gold Forward Curve
Similar to most currencies, gold is traded in several ways, including in the spot market. Spot gold prices are when the settlement is less than two business days. Most financial institutions play in the over-the-counter market and agree to deliver the gold to a counterpart’s vault immediately.
Most commodities have forward curves where delivery is agreed upon at some date in the future. A gold forward curve, or GOFO, is a swap rate for gold versus U.S. dollar interest rates. The GOFO is the price to swap gold for U.S. dollars, not the cost to lease it. The GOFO is the interest rate on a U.S. dollar loan secured by gold as collateral. The GOFO is the interest rate differential between the U.S. dollar and gold lease rates.
The Gold Forward Rate can be positive or negative. Similar to other currency differentials, it will describe whether it’s more expensive to own dollars or gold.
The forward gold curve can be backward, meaning future prices are lower than in the spot market. The price can also be contango which means that prices in the future are higher than spot.
Similar to other currency pairs, when gold is quoted in the OTC market for periods beyond the spot, a forward differential, also known as forward points, is added to the spot rate to derive a forward rate for gold. If the gold interest rate is higher than the U.S. dollar interest rate, the price you pay for a forward rate when you buy gold will be less than the spot rate. Alternatively, if the gold interest rate is less than the dollar interest rate, you will be a higher price than the spot rate if you purchase gold.
Different Ways Gold is Traded
There are several ways to trade gold other than the OTC market. Gold can be exchanged using gold coins, bullion, or bars. You can purchase gold through dealers or even governments. You can store the gold in your home, a vault, or a bank. There are some safety risks with holding gold in your home. There are some expense issues if you have physical gold in a regulated operator. If you purchase physical gold, you might want to have it insured to ensure you have recourse if it’s stolen. Gold bullion/coins and bars usually trade with a wide bid/offer spread. The cost of getting in and getting out is expensive. Lastly, you cannot short gold when dealing with physical gold.
When you short-sell gold, you are betting that the price will decline and transact security that will rise as the price of gold moves lower. Several products allow you to short-sell gold. These securities include, Contracts for Differences (CFDs), Futures, OTC transactions, and Exchange Traded Funds.
Contracts for Differences
CFDs are financial instruments that allow you to benefit from the change in the direction of an underlying asset such as gold. Instead of purchasing gold and using capital to buy gold, you purchase a security that tracks the movement of gold. There are several benefits to using CFDs. One of the most compelling is leverage. Your broker might only ask you to post a fraction of the value of gold. For example, if gold is $1,900 per ounce, at 20-1 leverage, you might only need to have equity of $10 to own an ounce of gold. When you open a CFD account, you will need to open a margin account. A margin account allows you to use leverage to trade CFDs. It will also allow you to short-sell gold and use a strategy that benefits if gold prices move lower. CFDs do not require that you ever need to take delivery of physical gold.
Futures
Gold futures contracts are another way to trade gold. A futures contract is the obligation to purchase gold at a date in the future. There are physically settled gold futures contracts that require the buyer to deliver gold from the seller on a specific date physically. There are also financially settled futures contracts, which only require a change of cash flows. Futures contracts are very liquid and are used for speculation and hedging. Futures contracts are also regulated. For example, in the United States, futures contracts are regulated by the Commodity Futures Trading Commission, which is part of the Securities and Exchange Commission. Similar to CFDs, futures contracts offer leverage.
You will also need to open a margin account with your futures broker, allowing you to use leverage and short-sell gold.
Exchange Traded Funds
Another widely used security that allows you to track the movements of gold prices is an exchange-traded fund (ETF). Usually, an exchange-traded fund that tracks gold will hold gold futures contracts or will have short futures contracts. You can buy an exchange-traded fund or short-sell an ETF. ETFs are usually traded in an equity account.
Gold Trading Strategies
There are several ways to trade gold and generate returns. One of the most common is the buy-and-hold strategy. You can employ a buy-and-hold strategy using physical gold, CFDs, OTC, Futures Contracts, and ETFs.
There are also plenty of technical analysis trading strategies. Technical analysis studies past price movements to determine the future direction of gold prices. For these types of strategies which usually require the ability to short-sell gold, you might consider using CFDs, the OTC market, Futures Contracts or ETFs. Technical analysis might evaluate a trend using moving averages or momentum. You might also look at ranges and decide if the price of gold is overbought or oversold. Many resources, including your broker, will provide you with information and strategies involving technical analysis.
Gold is also a commodity that rises based on supply and demand. You can follow the fundamentals of gold to determine if demand or supply will outperform. Gold is also quoted in U.S. dollars. Usually, when the dollar rises, gold prices become more expensive in other countries. To compensate for the rise in the dollar, gold prices generally fall. The reverse is also true when the dollar declines.
The Bottom Line
Gold can be traded both physically and financially. Gold coins, bars, and bullion can be purchased and stored in many locations. Physical gold is best suited for a buy-and-hold strategy. There are also financial instruments that track the movements of gold and will allow you to employ short-selling strategies to benefit from a decline in the price of gold. The most common instruments are over-the-counter transactions, CFDs, Futures Contracts, and ETFs. Before starting to trade gold, you should know some of the vehicles that will allow you to employ the best strategies for your risk profile.
