Why trade gold?

Gold has long been valued by societies all over the world for its inherent lustre and malleability. Nowadays, traders treasure gold (XAU/USD) because it is often viewed as the ultimate safe-haven asset, usually weathering market turbulence and retaining its value in periods of uncertainty. Traders also use gold to hedge against inflation and diversify their investments because gold often reacts differently to market stimuli than other assets.

What influences the price of gold?

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).

The U.S. dollar: One of the biggest points of contention for gold traders is the true correlation between gold and the U.S. dollar. Since 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.

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.

A Short-Term Strategy

The classic way for short-term traders to try to profit from gold moves is to use a moving average crossover strategy. In this strategy, a trader would seek 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.

For short-term traders, a 10/60 moving average crossover on the 1hr chart can be a strong combination. 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 below shows how this strategy could be applied in the gold market:

Gold 1 Hour Chart

At point #1, the shorter-term 10-hour moving average crosses below the longer-term 60-period average, suggesting that traders should enter a sell trade as a bearish trend may be forming. The moving averages do not cross again until point #2 a few days later after gold has trended down to the upper $1200s.

At point #2, the initial sell trade is closed for a solid gain and a new buy trade is triggered as the trend shifts back to the topside. After a brief consolidation, gold rallies back into the lower $1300s, and the trade is closed on the bearish moving average cross at point #3.

Like any methodology though, this strategy will produce losing trades as well. In this case, the big spike near point #4 caused the sell trade from #3 to be stopped out for a loss. It’s also important to note that the trade must be closed at the market price (near $1330) when the cross occurred, not the $1315 level where the two moving averages actually crossed.

A Long-Term Strategys

Longer-term position traders and investors can focus more on the fundamentals that drive 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.

Clearly there is a negative correlation, but with real yields falling below 1% in early 2009, gold seems to have bounced back even faster. Not surprisingly, over the longer term, this relationship reflects the general decline in gold prices in the late 1990s, characterized by real yields above the 1 per cent threshold.

Gold Price vs. TIPS Yield Since 2008

So if real yields fall below 1%t, a level that historically supports gold prices, long-term traders may consider buying opportunities. Conversely, if real yields rise above 2%, investors may want to focus more on sell trades.