How to Trade Gold

Gold is a rare precious metal that has many practical applications. It has been used throughout mankind's history as currency, jewelry and a store of value, among others. Owing to the fact that gold is closely linked with wealth, it enjoys a unique relationship with the financial markets.The Gold Standard, which was in effect for many years, backed the currencies of many countries around the world. By the time the Bretton Woods agreement was adopted in 1944, countries had fixed their currencies against the US dollar. Traders often turn to investment in Gold during times of volatile markets.The price of gold is made up of several important factors, including the following:

Gold Demand

An increase in demand for any commodity, including gold, has the effect of raising the price of that commodity, all things being equal. On an economic chart, the demand curve slopes downwards from left to right and the supply curve slopes upwards from left to right. The Y-axis represents price, and the X-axis represents the quantity. Without an increase in demand – represented by a rightward shift of a demand curve – the only way to increase the quantity of gold demanded is by decreasing its price.Gold suppliers will be unwilling to supply more gold as the price decreases, since this negatively impacts their overall profitability. A rightwards shift in a demand curve for gold can be brought upon by many different factors, including social, geopolitical, and economic.Investors hedge against inflation by purchasing gold as a store of value, since gold has unique properties that make it highly attractive as a long-term investment. Another important point to highlight is that gold demand tends to increase during times of upheaval, as investors seek cover from highly volatile equity markets and protection from losses in currencies.As you can see from the above chart, the price of gold has increased since the financial crisis began in 2008. The global uncertainty that racked the markets sent investors scurrying for cover.As is so often the case during times of economic downturns, gold demand soars. The reason why traders purchase gold during difficult economic times is to protect their investment portfolios against ruin. By allocating a greater percentage of your portfolio to gold (in uncertain times), you can hedge against inflation and grow your capital over the long-term.The same rationale explains the actions of European investors from 2009 onwards. As European unemployment increased, inflation fell to record lows, economic growth stagnated and a currency crisis took hold; investors feared that their funds would be wiped out and decided to invest in gold. By late August 2011 gold had reached over $1880 per ounce, and it traded within the $1600 - $1800 range until the end of 2012.

The Gold Price & the USD

As we pointed out earlier, the Gold Standard was linked to the value of currencies. As the demand for gold increased, its price relative to the dollar spiked. By 1975, currencies around the world were no longer pegged to the US dollar and a free-floating exchange rate system was adopted. Consider for a moment how the average gold price per troy ounce has increased:

• 1920  -  $20.68
• 1940  -  $33.85
• 1960  -  $35.27
• 1980  -  $615.00
• 2000  -  $279.11
• 2005  -  $444.74
• 2008  -  $871.96
• 2011  -  $1571.52

Based on the information provided above, gold has historically outperformed currencies as a store of value by a tremendous margin. This is the reason why traders see the precious metal as a safe haven investment.The relationship between the gold price and the strength of the US dollar is a curious one. The US dollar index – an index measuring the dollar against a basket of currencies – reveals that the dollar depreciated in the first and second quarters of 2011, but the gold price appreciated at that time.The inverse relationship has proven itself true over multiple cycles. As the dollar loses value, gold prices increase, and as the dollar gains value, gold prices decrease.When traders fear the consequences of a weak US dollar, they seek a safe haven investment in gold. This causes gold prices to rise. When the dollar is strong, traders prefer to invest in more productive assets, placing funds into the stock market to take advantage of higher possible returns. Gold typically thrives during times of high volatility and uncertainty.

The Final Word

Gold demand, price and volatility are affected by a myriad of factors. By keeping your ear close to the ground, you can catch market trends as they happen.Gold traders utilize a combination of technical analysis and fundamental analysis which can be used to enter profitable positions vis-a-vis gold. It is a highly volatile commodity, but gold is not expected to lose its importance over the long-term.