In recent years gold has changed from a range-bound, listless market to one of the hottest in the commodity sector. Traditionally, markets such as palladium, the Japanese yen and coffee are considered the “big trenders.” That has changed. Gold has joined the club.
Because of that, many traders that never before considered gold are looking at the yellow metal, but you should never dive into a market unprepared — not even one as familiar to all of us as gold. You first need to cover the basics.
It all starts on the trading floor, or perhaps trading screen. Traded on many futures exchanges, the main market for gold is the Commodity Exchange, or Comex, in New York but Comex is being challenged by the Chicago Board of Trade’s (CBOT) electronic gold contracts. Not only can you trade a liquid full-sized gold contract on the screen but the CBOT also offers a mini contract for smaller traders.
Coveted for centuries for its rarity, indestructibility and beauty, investors embrace gold, from individuals to countries, as both a method to insure against adversity and for pure speculation. Gold futures and options are a more efficient investment than coins, bullion and gold stocks. While gold exchange traded funds (ETFs) are growing in popularity, they cannot provide the margin advantages of futures.
While the allure of gold is thousands of years old, the modern day story of gold investing begins in 1944. With the Bretton Woods agreement, all of the world’s paper currencies were fixed to the dollar and, in turn, were tied to gold. The agreement was in force until 1971 when President Nixon effectively cancelled it by ending the convertibility of the dollar into gold.
Since then, gold prices have been free to float and have been set by supply and demand factors.
Interest in gold futures is higher than at any other time in the last 20 years. Not only is demand building, but new speculators seem to be coming to the plate. New speculators equal more liquidity, which is a key ingredient for a trending market.
If gold of the 1990s was dominated by low volume and poor trends, the added attention gold is getting, due in part to making historically high prices, could bring in even more investors and new and more robust trends.
Another reason is inflation. If inflation is in fact gathering momentum, the resulting push to gold is an inevitability. One of the key elements fanning the inflation fires is the roller-coaster ride known as the crude oil market. Inflation is the sustained increase in the price of goods and services, and professional economists and everyday people use the price of crude oil as their inflation compass. In the chart “What next” you can see how gold reacted during the hyper inflation days of the late 1970s. The six-year rally during the current period of relatively stable inflation pales in comparison.
As our hard-earned dollars have decreasing purchasing power, many of us mentally flip the “on” switch for an imaginary inflation sign. As more investors flip those switches, the hardwired connection is made and they instinctively start looking at items like gold to hedge their bets and portfolios.
Economic uncertainty is another key consideration. How much we worried about Y2K seems silly in the face of today’s threats, such as a potential real estate bubble that would affect every property owner in America, the inverted yield curve, the war in Iraq and Iran’s nuclear intentions. And, speaking of uncertainty, how about China coming online as a world consumer of energy and resources? While not as quantifiable as the Middle East situation, the shear numbers that China boasts, and what it means to the world economy, qualifies as a form of economic uncertainty.
The bottom line is regardless of where you think gold will go, a lot is going on in the world today that affects the yellow metal. It’s a good time to be watching this market. There will continue to be many profit opportunities on both sides of the market.
STRATEGIES & TOOLS Gold tends to correlate with different markets and market sectors, right now it’s crude.
The price action of gold and crude oil from 2000 to 2005 indicates the two markets are moving in tandem. Further, note the angle of the trends for these two inflation barometers. Absent are the spiky, blow-off tops typical of trending markets at the end of their run. The gold and crude oil markets work together and feed off each other. They are likely to pull each other higher in the near future.
“Base in volume” shows gold during its big run at the end of the 1980s. Typical of strong markets, gold’s volume grew as the bull market gained steam. Anytime gold retreats back to support areas there are buying opportunities.
Buying call options also may be a viable way for investors to participate. Keep in mind the risk level will be high for both of these instruments. As prices get higher, the retracements will get bigger. This is not the gold market that was on holiday for the better part of 15 years. Swings of $3,000 to $5,000 per contract are going to be commonplace. Meter your risk accordingly.
Scot R. Hicks is senior vice president for California-based Trade Center LLC.