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So everyone’s talking about trading gold. What is it all about?

Human beings have long valued and treasured gold for its inherent luster and malleability. In fact, gold has been used in human commerce since the societies of the ancient Middle East over 2,500 years ago, making it the oldest form of money still recognized today. Gold’s long track record as a store of value despite wars, natural disasters, and the rise and fall of great empires means that it is generally seen as the ultimate “safe-haven” asset.

While gold has generally held its value for centuries, traders’ interest has waxed and waned in recent years. From the early 1980s until the early 2000s, there was little interest in trading safehaven gold amidst the strong, stable economic growth and high-flying stock markets. As a result, gold generally consolidated between $300/oz and $500/oz for twenty years, from 1982-2002.

Interest in gold grew slowly through the 2000s before exploding with the onset of the Great Financial Crisis in 2008. Gold prices rose in sympathy, hitting an all-time high above $1900 in late 2011. In this guide, we will discuss the major forces that drive gold prices, along with some ideas for trading strategies and some of the most common methods for trading gold.

Factors that influence gold’s price

Gold is one of the most difficult financial assets to value. Gold is similar to a currency like the U.S. dollar or the euro because it is durable, portable, uniform across the world, and widely accepted; however, unlike these more commonly traded currencies, gold is not supported by an underlying economy of workers, companies, and infrastructure. In other ways, gold is more similar to a commodity like oil or corn because it comes from the ground and has standardized physical characteristics. But unlike other commodities, gold tends to fluctuate independently of industrial supply and demand.

In fact, only about 10% of the world’s gold is used in industry: primarily in electronics, due to its conductivity and anticorrosive properties. The rest of the world’s gold is either made into jewelry or held for investment purposes.

Because of this dynamic, the emotions and behaviors of traders tend to drive major trends in the yellow metal. With gold more than any other asset, traders seem to be polarized between diehard “gold bugs” who believe that gold should be worth $10,000 an ounce because central banks around the world are debasing their currencies and bearish traders who assert that gold is a “barbarous relic” of the past that should be worth closer to $100. As the chart above shows, the gold bugs’ view developed into a bit of a mania back in the mid- and late-2000s, though the more recent drop suggests gold may be losing some of its previous luster.

GOLD AND U.S. INTEREST RATES

Historically, one of the most reliable determinants of gold’s price has been the level of real interest rates, or the interest rate less inflation. When real interest rates are low, investment alternatives like cash and bonds tend to provide a low or negative return, pushing investors to seek alternative ways to protect the value of their wealth.

On the other hand, when real interest rates are high, strong returns are possible in cash and bonds and the appeal of holding a yellow metal with few industrial uses diminishes. One easy way to see a proxy for real interest rates in the United States, the world’s largest economy, is to look at the yield on Treasury Inflation Protected Securities (TIPS).

What is the correlation between gold and the U.S. Dollar?

For gold traders，one of the biggest points of contention is on the true correlation between gold and the U.S. Dollar. Because gold is priced in U.S. Dollars, it would be logical to assume that the two assets are inversely correlated, meaning that the value of gold and the dollar move opposite to one another. In short, it takes fewer dollars to buy an ounce of gold when the value of the dollar rises, and it takes more greenbacks to buy an ounce of gold when the value of those dollars is lower.

Unfortunately, this overly simplistic view of the correlation does not hold in all cases. The chart below shows the rolling 100-day correlation coefficient between gold and the U.S. Dollar. The correlation coefficient measures how closely together gold and U.S. dollar have moved over the last 100 days; a reading of 1.0 would show that they moved in perfect lockstep with one another, while a reading of -1.0 would show that their movements have been diametrically opposed.

As you can see, the correlation is negative the majority of the time, showing that the U.S. Dollar does tend to move opposite to gold.

Gold trading strategies

As with any trading instrument, there is no single “best” way to trade gold. Many traders from other markets have found that the technical trading strategies they employ on other instruments can easily be adapted to the gold market, especially given gold’s tendency to form durable trends. For example, many traders have found success adapting strategies based on trend lines, Fibonacci analysis and overbought/oversold oscillators like RSI and Stochastics.

A SAMPLE SHORT-TERM STRATEGY: CATCH THE “BEST” OF THE TREND WITH A MOVING AVERAGE CROSSOVER

For short-term traders, a classic way to try to profit from the frequent trends in gold is to use a moving average crossover strategy. In this strategy, a trader would look to buy gold if a shorter-term moving average crossed above a longer-term moving average and sell when the shorter-term moving average crosses below the longer-term average.

Traders differ in their opinions on the “best” time frames for the two moving averages, but we’ve found that a 10/60 moving average crossover on the 1hr chart can be a strong combination for shorter-term traders. Historically, these settings have allowed traders to successfully trade the middle portion of a trend, though there is no guarantee of future performance. The chart shows how this strategy could be applied in the gold market:

This simple trading strategy can help traders catch the middle portion of trends in more volatile trading environments like the one highlighted above, but using it when gold is merely consolidating in a range can lead to a series of consecutive losing trades. As a result, traders may want to consider supplementing this strategy with other indicators to improve its long-term profitability.

A SAMPLE LONG-TERM STRATEGY: WATCH THE LEVEL OF REAL INTEREST RATES

Longer-term position traders and investors can focus more on the fundamentals driving gold’s price, such as the level of real interest rates. The chart below shows the relationship between gold prices and the yield on TIPS, a proxy for real interest rates in the United States. The inverse correlation is obvious, but it looks like gold’s rally accelerated as real yields dropped below 1% in early 2009. Not surprisingly, a longer-term look at the relationship would reveal that gold prices generally fell in the late 1990s, which were characterized by real yields above the 1% threshold.

Therefore, longer-term traders may want to consider buy opportunities if real yields are below 1%, a level which has historically been supportive of gold prices. Conversely, if real yields rise above 2%, investors may want to focus more on sell trades. Of course, this relationship between real yields and gold prices plays out over longer-term timeframes, so shorter-term gold traders can generally ignore the level of interest rates.

The ability to use a filter based on real interest rates is one of the unique features that traders can use to gain an edge when trading gold, but the trading strategies and opportunities in trading the world’s oldest “currency” are truly limitless.