What is Gold? Understanding Gold as a Trader's Commodity
Gold is among the most valued commodities in the world, with a history of utility in currency and jewelry as well as being a favored safe haven asset. In this article, discover what gold is used for, the history of the market and how it works, and what affects gold prices.
MAIN TALKING POINTS
- What is gold and what is it used for?
- What affects gold prices?
- How can gold be traded?
WHAT IS GOLD AND WHAT IS IT USED FOR?
Gold is a precious metal coveted throughout history for its vibrant color, malleability, and relative scarcity. It has industrial applications in electronics and computing, and is enduringly popular as a jewelry-manufacturing component. Gold has always been used as a monetary instrument, as well as a safe haven asset due to its tendency to retain or increase its value during periods of market turbulence.
HISTORY OF GOLD AS AN ASSET CLASS
For thousands of years, humans have placed a high premium on gold. It has represented the currency of some of the world’s most famed civilizations, such as the empires of Ancient Egypt and Rome. More recently, from the late 19th century up until the outbreak of World War One, the value of currencies have been anchored to a specific amount of gold.
Starting at the end of the World War Two, most of the planet’s largest economies operated within a financial system based on a set gold price, which was tied to the US Dollar. This only ended in 1971, when the US opted to stop aligning its dollar with the commodity.
While the precious metal no longer functions as an official currency, the gold price remains a highly influential element in financial markets and world economies.
WHAT AFFECTS GOLD PRICES?
The factors that affect gold prices include stability, supply and demand, central bank exposure, and volumes traded through ETFs.
As the bedrock financial instrument underlying global currencies, gold is considered a fairly secure asset. Its price tends to rise in times of turmoil, as governments and investors turn to it as a hedge against uncertainty. Inversely, gold prices usually drop in stable times, as riskier yet potentially more profitable avenues of investment become more viable.
As with most assets on the open market, an excess of demand for gold (normally for jewelry-making, or manufacturing certain medical, industrial and technological products) drives up the gold price (assuming supply is constant). On the other hand, a weakening of demand often has the opposite effect on its value, sending the price lower (assuming supply is constant).
Many of the world’s gold reserves are controlled by central banks within developed nations, in locations such as Europe and North America. As a result, these banks wield immense pricing power in global gold markets. If the banks suddenly increased or reduced their gold exposure at once, even slightly, this would have a magnified effect on the gold price. Central banks therefore rely on a joint (though unofficial) commitment to refrain from unilaterally engaging in large-scale gold sales that could destabilize global markets.
While exchange traded funds are generally intended to mirror the gold price rather than influence it, many large ETFs hold a significant amount of physical gold. Therefore, the inflows and outflows from such ETFs can affect the metal's price, by altering the physical supply and demand in the market.
HOW GOLD AFFECTS CURRENCIES
When it comes to gold’s relationship with currencies, its correlation with USD is a principal talking point as the US Dollar remains the benchmark pricing mechanism for gold. When the value of USD increases, gold becomes more expensive for other nations to purchase.
This ultimately causes demand to fall, which is why there’s generally an inverse relationship between the US Dollar and the gold price. Additionally, when the Dollar starts to lose its value, investors look to gold as a safe-haven alternative and this helps to push its price up.
The below chart shows this inverse relationship between the US Dollar Index and gold.
GOLD PRICES OVERLAID AGAINST THE US DOLLAR
Also, the value of gold is linked to the value of a nation’s imports and exports. Countries that export gold or have access to gold reserves will see their currencies strengthen when gold prices rise, due to the value of the country's total exports increasing.
HOW CAN GOLD BE TRADED?
There are a number of ways to trade gold, as explained in our in-depth guide to gold trading. It can be purchased as a physical asset, traded using futures and options in the commodities market, or traded through an exchange traded fund or ETF. For more information on each of these, click on the link above. For more information on each of these, click on the link above.
Reasons to trade gold
Traders might consider trading gold because:
- As a safe haven in times of economic turbulence, when it tends to hold its value or appreciate
- To capitalize on a weak US Dollar, and hedge against inflation
- To maintain a diverse portfolio of commodities, stocks, bonds etc.
FURTHER READING ON GOLD AND COMMODITIES
Make sure you keep up to date with gold market projections by downloading our free quarterly Gold Forecast.
We also recommend reading our guide on trading the gold-silver ratio, which is useful for many traders looking to compare gold’s performance with that of silver. Weighing up whether to choose gold or cryptocurrencies? Read our Bitcoin vs Gold article.
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