Gold Trading Insights: Technical Analysis, Economic Factors, and Trading Strategies

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Gold (Part 2)

– The London fix

In the prior chapter, we looked at the variety of Gold contracts on offer from MCX. This time around, let’s dive into how prices of Gold in the spot market are calculated across India and abroad. While it does not directly reflect trading gold futures in MCX, it is still an interesting thing to learn.

The price of Gold is fixed twice a day in two London-based sessions. At 10:30 AM it’s known as the ‘AM Fix’, and at 3:00 PM, the ‘PM Fix’. This is achieved with the assistance of Nathan Mayer Rothschild & Sons, who facilitate the process on behalf of the largest gold dealers in London.

Around 10-11 banks are actively involved in the process, which includes names such as JP Morgan, Standard Chartered, ScotiaMocatta (Scotiabank), and Société Générale. Access by the general public and other banks is strictly prohibited. These dealers make a call to a specified conference line at the given time with their bids and offers of gold. The average between these figures is then passed on to the market, thus forming the benchmark for gold trading. This whole procedure lasts for about 10-15 minutes before being repeated in the ‘PM session’. The resulting prices are once again released to the markets.

The gold price determined by the AM and PM sessions generally reflects the same rate as gold traded at international markets such as London. Thus, traders and bullion dealers aren’t surprised by this valuation. In fact, some participants feel that this practice has more to do with tradition than anything else – an opinion that is typical of British culture.

India also has similar gold import and pricing practices, though less elaborate. It is one of the biggest consumers of the precious metal and imports gold through authorized banks, who in turn supply it to bullion dealers, with added charges. The Indian Bullion Association then bids for this gold via its nationwide dealers. Rates are set in accordance with how much gold dealers want to buy or sell at a given price – these rates are averaged out and set the floor for Indian Gold prices. There is somewhat of a cycle as dealers use MCX-traded Gold futures prices before they place their bids with the association. This Price is transmitted to dealer and jewellers’ networks which eventually determines the daily rate.

8.2 – Gold price disparity

Traders usually examine the Gold futures rate in Chicago Mercantile Exchange (CME) and MCX to determine whether an arbitrage is feasible. This is due to the notion that Gold, as a global commodity, should generally cost the same, thus forming an arbitrage opportunity if this is not the case. To illustrate this, if 10 grams of 995 purity Gold on CME is identified at $430, then 10 grams of the same purity in MCX should be approximately $430.

The disparity between gold futures contracts on CME and MCX is often notable, trading at significantly different prices. But what could explain this difference?

Let us figure this out –

To grasp the contrast between the two futures contracts, one should comprehend the dynamics of the Gold spot rate in India.

Take into account that India is a net gold importer. Gold is quoted per troy ounce in the US markets, which is equal to 31.1035 grams. When considering the spot price of gold in India, bear in mind it stands at $1320/troy ounce across the US. Using this rate and an exchange rate of $1=Rs 65, what would you estimate the Indian gold spot price should be?

We will calculate the cost of 10 grams of gold by multiplying it with the current U.S. dollar to Indian rupee exchange rate. Let us do this math swiftly –

31.1 Grams = $1320, therefore 10 grams = $424.43. Since USD INR is at 65, the price of Gold in India should be approximate = Rs.27,588/-.

It is not a simple matter to import Gold. Banks, being the importers, must pay duties and taxes, meaning that the spot price of gold in India must include all these charges. When importing this precious metal, banks encounter the following costs:

  1.     CIF applicable in Dollars (CIF stands for cost, insurance, and freight)
  2.     Custom duty
  3.     Cess
  4. Bank cost

The cost of Gold tends to increase due to the various charges associated with it. 

In the US, the rate of spot Gold stands at $420 per 10 grams. After accounting for all related expenses in India, we can estimate the spot rate to be $435 – indicating a difference of $15.

This clarifies the difference in spot prices, but what do we know about futures prices? They are calculated from spot rates, and the formula to derive them is –

F = S*e(rt)

You can read more on futures pricing.

In the US, the basis for future gold prices is the spot price of $420; similarly in India it is $435. This discrepancy between CME and MCX shouldn’t be mistaken as a chance to arbitrage.

8.3 – What drives the gold price?

It’s no surprise that, when economic uncertainties arise, investors act quickly to make gold purchases. After all, it’s a long-standing safehaven protecting against financial disruption.

The Brexit of June 2016 shook the world. Let’s consider how Gold behaved in the lead-up to and in the aftermath of this momentous occasions.

Before the event, Gold had been on a clear rise, and its biggest peak came the day after the Brexit verdict was announced. This surge in Gold was mainly due to the uncertainty surrounding Brexit, and it’s reflective of its reputation as a safe harbor for investors’ wealth.

It’s plain to see that virtually every significant event in the past has affected gold, be it the oil crisis, turmoil in the Middle East, Israel-Palestine conflict, European migrant issue, Greek debt crisis or collapse of Lehman Brothers. The list is seemingly endless. The point is that gold prices are influenced by global developments.

This leads us to an important conclusion – Gold tends to increase in value in the backdrop of economic uncertainties. In fact, in the backdrop of economic uncertainties, demand for risky assets such as equities goes down, and the demand for safe-haven assets such as Gold tends to increase.

Investors often purchase gold for protection against inflation and a steadying of their portfolios in the face of uncertain events. This is a sensible decision as evidenced by a long-term chart of gold’s performance which reveals its value increase over time.

Examine the chart above and note that in 1970, Gold was valued at approximately $35, whereas in 2016 it has risen to $1360; this translates to a 37x return. When looking at it through a CARG perspective, the growth can be seen as 8% on an annual basis. The typical global inflation rate is usually between 5-6%. Because of this, if you invest in Gold you can expect to earn 8%, but lose 6% eroded away by inflation – resulting in an outperformance of 2%. Unfortunately though, if you are located in a country with higher inflation levels such as India, investing in Gold will not bring back significant returns.

– Gold, Dollar, Rupee, and Interest rates

Trading in gold requires traders to pay attention to world economics, currencies and interest rates. The dollar usually forms the basis for this equation. Therefore, keeping an eye on its movement is of utmost importance.

Have a look at this graph below –

The value of USD is inversely proportional to the price of Gold. This can be attributed to two primary causes: the impact of global economic events, and the demand for gold as a safe haven asset. As one increases, the other decreases in value.

  1.     When the dollar weakens in comparison to another currency, this leads to an appreciation of the latter’s value. Likewise, the demand for commodities, particularly gold, rises accordingly. As such, the price of gold is likely to elevate as a result.
  2. Due to a weakened US dollar, investors are seeking out safer havens for their money, typically turning to gold.

It’s worth noting that this may not always be the case. Take the situation in Saudi Arabia, with the decline of oil prices, domestic investors might look to secure their funds in assets like gold and USD. This could lead to an increase in both asset values.

It’s obvious that USD is a factor in the value movement of Gold. To confirm this, we need to check for correlations between numerous variables and gold. Take the US federal rates, for example; these usually strengthen the US Dollar, so you’d think gold prices would reduce in consequence. Yet, this isn’t always the case – it looks like the correlation coefficient between Gold and Federal rates isn’t even as high as 0.3.

It may seem contradictory, as I mentioned previously that a strong dollar tends to lead to lower gold prices. However, this may not be the case when it comes to the various factors affecting USD and gold prices.

Confusing? Yes, it is, I agree.

Trading gold is an elaborate exercise and it requires comprehension of various demand and supply factors. Charts that manifest themselves in prices can be studied using Technical Analysis, which will lend you valuable trading insights.

When it comes to stocks, I’m definitely into Fundamental Analysis, but for commodities and currencies, I prefer to use charts.

– Technical Analysis of Gold

If you are not familiar with Technical Analysis (TA), then you can read the module on the same. 

TA is a useful tool that can be employed to assess the performance of a variety of assets, including currencies and commodities. I would like to share some trading insights on gold that have been produced with the help of TA. Hopefully, this will provide you with an understanding of how TA can be applied to gold.

The goal when trading Gold is to quickly complete a short-term transaction; I do not strive to hold the position for an extended period of time.

When I’m constructing a trading view, the first step is to assess the two-year end of day chart of Gold Bees (ETF). This chart gives me an insight into the primary trend of Gold, as well as highlighting any key price points.

From the chart above, I note the following points –

  1.     Gold declined to start from late 2013, all the way to late 2015.
  2.     Prices bottomed over the last few months of 2015.
  3.     Gold in fact formed a double bottom between Sept-Dec 2015.
  4.     Prices have been trending up since early 2016.
  5.     Traders have bought Gold at every decline starting from early 2016.
  6. Clearly, the bearishness in gold is no longer there, and this is evident given the fact that gold has scaled back to 2013 prices.

I have concluded that I am more comfortable with long-term trades than short, but I will still consider opportunities to short if the risk-to-reward ratio is attractive enough. In such a case, I will be aware that other traders are likely looking for chances to buy gold at every dip so caution needs to be taken and any short positions should be monitored closely. To this point, my view on Gold is rather general and I have not ventured into any specific price level yet.

I am now eager to analyse the short term chart of Gold, to seek out trading opportunities. Let us begin by examining the left side of the chart, and then proceed to search for potential trades on the right side. Here is the chart:

Beginning in late 2015 till approximately June 2016, the graph shows a lack of activity. Both the volume and prices demonstrate this, as the amount is almost nonexistent while they fluctuate rather drastically. Can you explain why?

Gold contracts are usually introduced 12 months prior to the actual expiry so for example the October 2016 contract that we’re considering was launched around October 2015. It doesn’t start to draw liquidity until it’s nearing its due date, however if our markets were thriving with high liquidity probably it would have taken in more activity earlier.

We will now direct our attention to the left side of the chart and check for any trading opportunities. To draw more attention, I will again post the same chart with the recent candles marked. On top of that, 9 and 21-day exponential moving averages have been placed over the prices.

  1.     The current market price is below both the short term averages.
  2.     The three price action zones from the recent past were at around 30956, encircled in blue circles. Since the current market price is below this level, it serves as an immediate resistance.
  3. We can see a Bearish Marubuzo (circled in black) in the recent past which has played out admirably. It is likely that traders have cashed in on this formation.

After assessing the above factors, I will purchase gold if it surpasses the 30956 resistance level, as this corresponds with the two short term moving averages. Conversely, if the metal remains below this point, I would be unwilling to trade on its decline due to our earlier conversation. In conclusion, my strategy would look something like this –

o   Position: Long

o   Price: Above 30956

o   Target: 31418 (have placed a short blue line)

o   Stoploss: 30700 (current market price)

o   Reward to risk assuming I’m going long at 30956: 1.8

o   % move from entry – 1.5%

It appears to be a sensible and profitable exchange if weighed from a risk-versus-reward angle. One could see the desired 1.5% move occurring in no greater than one day’s time.

The purpose of this discussion is to explain how Technical Analysis is applicable to commodities, such as Gold.

I hope the past two chapters have provided enough insight into Gold trading so that you are now well-positioned to get started.

Let’s head to Silver in the next chapter!

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