Gold. A shiny metal that only a very few people understand. Why is it so valuable? Why is it one of the most traded commodities? Why does the American government have a lot of gold reserves? Why is it the top prize in major competitions such as Olympics and World Cup? These are some of the main questions asked by many people. In my experience as a trader, I have constantly traded or used gold as an indicator of market movements. I believe that all traders should do the same too. Critics of gold raise a number of issues about gold. One, why would one invest in gold which does not pay interest? Second, they question the basic fundamental of buying and owning a metal with no intrinsic value. The first question has been solved as a number of countries belong in the negative interest rate territory. Here are some of the main reasons you should be interested in trading gold.
1 - DIVERSIFICATION
One of the most common laws of trading is diversification. The best way to diversify is to find instruments that have an inverse relationship with one another. Then, you should short and long these instruments. Historically, gold has had an inverse relationship with stocks and the dollar. In the 70s, after Brenton Woods was a positive for gold and negative for stocks. In 80s, it was a terrible period for gold and a fantastic economy for stocks. In 2008, stocks fell while gold went up as investors moved to safety. In the same way, in 2015, the dollar strengthened against major currencies and gold went down. Therefore, having gold in your portfolio will be a hedge against major market movements.
2 - INCREASING DEMAND
As a country’s economic growth rises, the demand for gold grows. This is because more people will buy gold-made items such as ornaments and furnishings. The global economy is growing, though at a slower-than-expected rate. But its growing. This growth is leading to more demand for gold which has played a role in the recent bullish trend.
3 - SUPPLY PROBLEMS
The law of demand and supply states that an increase in supply leads to higher prices. The demand is rising while the supply is reducing. In South Africa, labor problems are common which threaten the supply of gold. Statistics indicate that gold production fell from 2,573 metric tons in 2000 to 2,444 in 2007. 2015 was a tough year for commodities as their prices fell with many miners such as AngloGold reporting losses. Therefore, with reduced production, chances are that gold prices will keep on going up.
4 - GEOPOLITICAL UNCERTAINTY
Gold unlike other commodities are rarely affected by geopolitical issues. For instance, when there is a crisis in the Middle-East, chances are that the price of crude oil will go up. This is because oil is a ‘mass’ commodity. On the other hand, gold is not a mass market product. Gold is known as a crisis commodity because in times of massive global tensions, investors tend to flock to it. This makes gold an important hedging tool against major global geopolitical issues.
5 - INFLATION HEDGE
Gold is the best tool to hedge against major global financial issues. One of these issues is inflation. This is because the price of gold tends to go up when inflation goes up. Since the end of World War 2, inflation was highest in the following years: 1946, ’74, ’75,79, and ’80. During these years, the returns at the Dow Jones were about 12.3% compared to gold’s return of 130.4%. Gold is also an important hedge against a weakening American economy because it tends to rise when the economy is not doing well. For instance, last week the jobs number was released showing a weakening economy. After the announcement was made, the dollar fell while gold and treasuries rose. This shows how the correlation between the economy and the dollar is. For day traders, I recommend that you take time to understand how to trade gold and how gold moves on an intraday basis. Understanding gold behavior is not as easy as I have explained in this article. In fact, it takes a lot of skills to effectively trade the commodity. By reading books and watching videos, you will learn how to conduct correlation tests and make better decisions.