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Gold Again Near All-Time Highs: What’s Next and How to Trade It

Gold Again Near All-Time Highs: What’s Next and How to Trade It

2011-02-28 21:27:00
John Kicklighter, Timothy Shea, Market Analyst,

Gold has been on a tear to the upside, having more than doubled in the past four years. This is even more impressive when you compare gold to other investments, such as stocks. Over this time, stocks have struggled to produce any significant return for investors, and many stock indices remain significantly below their levels of four years ago. Even “safe haven” assets such as government bonds have struggled to produce a return recently as interest approach zero. It’s no surprise that so many investors’ minds have turned to gold.

Gold_Again_Near_All-Time_Highs_Whats_Next_and_How_to_Trade_It_body_gold_weekly.png, Gold Again Near All-Time Highs: What’s Next and How to Trade It

So, with such a long and powerful bullish trend seemingly in place, how do you take advantage? With newspaper headlines of new highs and the public chatter about gold, many new traders will simply buy and assume that they are not too late to the trend. By stepping into the market without preparation, these traders could be joining just in time to be wiped out by a major reversal. Before getting in, it’s important to know the answers to gold trading’s essential questions.

Why has gold gone up so much in the past few years?

Historically, gold has been treated as a financial “safe haven”. As recently as the 1970s, gold was the basis of many currencies, and gold is still what many investors run to when things get a little too scary. The financial crisis of 2007 and 2008 proved no different. As stock markets plunged, banks were bailed out, and corporate debts went bad, gold gained by nearly 50% in US dollar terms. When measured against more “risky” currencies, such as the Australian dollar, the rise is even more dramatic. With the collapse of Lehman Brothers and the nationalization of AIG, investors everywhere fled to two things: gold and US Treasury bonds.

What has been even more extraordinary has been gold’s subsequent rise past $1,000 per troy ounce and beyond. As mentioned above, typically risky assets—such as stocks—tend to move in the opposite direction of gold, as markets embrace or reject risk. When markets fear risk, gold tends to rise. Also, historically, when markets embrace risk and become optimistic, gold tends to fall. However, as risk appetite has returned in the wake of the financial crisis, both stocks and gold have risen dramatically, each rallying by more than 50%. Why the change?

Gold_Again_Near_All-Time_Highs_Whats_Next_and_How_to_Trade_It_body_int_rates.png, Gold Again Near All-Time Highs: What’s Next and How to Trade It

Well, where else are you going to put your money? Companies’ earnings outlooks are weak as developed economies continue to drag and unemployment remains stubbornly high. That keeps dividends low, and has kept many people out of stocks. US Treasury yields are at historic lows, leaving little chance for income from bonds or interest rates. Also, with the United States taking on record peacetime debts, there is a lot of downside and very little upside in Treasuries. So much for safe haven. European debt has Greece, Ireland, Portugal, and Spain to worry about. The Federal Reserve, European Central Bank, Bank of Japan, and Bank of England are all printing money to prop up their economies and have no plans to raise interest rates anytime soon. Japan and China are intervening to keep their currencies cheap, and other countries may join them. Every country in the world wants a cheaper currency, so cash is looking likely to lose value. That leaves gold.

Finally, the cost of holding gold has gone down. Traditionally, the big impediment to buying gold was high interest rates. Gold pays you nothing to hold. No interest, no dividends, nothing. A few years ago, most investors and central banks would avoid buying gold, preferring to invest in assets that paid income in the form of interest or dividends. With interest rates at such extreme lows, that headwind is gone—you’re not missing much by holding something with no income. Also, borrowing is so cheap that it makes sense for many traders and funds out there to borrow in order to leverage up their gold trades.

So, despite the older historic trend, it looks like gold can rise when other markets rise or fall.

Can gold keep rising? How high can it go?

Gold can definitely keep rising. So long as governments continue to print money to stimulate their economies (and thereby erode the value of their currency), investors will want a physical store of value like gold. With interest rates low, the costs to own gold and to borrow to own gold are low. On the other hand, if all hell breaks loose again, gold’s traditional safe haven status will serve it well. How high it can go depends on how these factors play out. While gold at all-time highs means we are in mostly uncharted territory in nominal terms, we can look at gold in real terms as well. The previous high in 1980 of $850 is worth over $2,000 in 2010 dollars once adjusted for inflation. Maybe we have been here before.

Can gold prices crash from here?

Absolutely. Like any large speculative market move, gold’s rise has been a self-fulfilling prophecy. Gold has relatively few practical uses, but a lot of speculators. Its price rises because speculators are buying. And speculators keep buying because the price is rising. Speculators borrow at the current low interest rates to buy more gold to amplify their gains. The price rises further, so they can afford to borrow more to buy more, which pushes up prices yet again.

At some point, the music stops. One likely cause would be when governments end their support of the economy and interest rates start to rise. Higher interest rates would make it more expensive for speculators to borrow and hold gold. As some speculators sell their gold, prices fall. Many others in the market see the price fall and may decide that the sidelines are a good place to be, rather than paying interest to hold a falling asset. Generally, any asset that has a lot of speculators will tend to have violent declines and reversals, as all the speculators are watching the price, and are ready to jump out when it goes against them. With all the ways that individuals can access the gold market these days—physical gold, CFDs, futures, ETFs, etc.—there are a lot of speculators out there. And a lot of them don’t know what they’re doing.

How should I trade gold?

Being so speculative, gold has a history of steady advances and violent reversals. So how should you trade it? Considering that price drops can be powerful, it is important to be cautious with your trade size and your leverage, being careful to not be overly aggressive.

The first thing to remember is to never fight the trend. The road from $300/oz gold (2002) to $1,400/oz (2010 and 2011) is littered with the shattered hopes and smashed trading accounts of speculators who tried to pick the top by selling gold short. Trying to short an up-trend like gold is like stepping in front of a moving train. It will be really awesome if the train stops before hitting you, but that’s unlikely to happen. It’s much more likely that things will not end well. While the trend in gold remains up, you should only choose between two possible positions: long or neutral. Never short.

When the trend changes, then you may short, but only once it is absolutely certain that the trend has changed. One commonly used indicator is the long-term moving average. Many traders will use the 50-day and 200-day moving averages. When the 50-day is consistently above the 200-day and moving up, the trend is up, and you should not even consider shorting. When the 50-day crosses the 200 and heads down, only then should you consider shorting.

What strategies should I use to trade gold?

The best trading strategies for a market like gold are momentum and breakout strategies.

Momentum: Momentum strategies aim to take advantage of the consistent trend. This typically requiresyou to hold a trade for a longer period of time (days or perhaps weeks at a time). Since you are looking to catch the big, long move, start small. You’re in for the long run, so excessive leverage should be avoided. Gradually add more and more to your position as the trade starts working for you. Do not add if the trade is negative. Using a trailing stop is critical to ensure that a violent reversal doesn’t wipe out any profit you may have already won.

Gold_Again_Near_All-Time_Highs_Whats_Next_and_How_to_Trade_It_body_gold_momentum_weekly.png, Gold Again Near All-Time Highs: What’s Next and How to Trade It

Trendlines, moving averages, and volatility indicators are the most important technical indicators when setting up a momentum trade. Use trendlines to see the outline of the trend and to help find reasonable entry points. Moving averages can help determine if the market is climbing or if it has pulled back enough that it is prudent to get out of the trade. A common moving average combination is the 10, 20, and 50-day moving averages. When the 10-day average is above both the 20 and 50-day averages (all three are rising), the market is consistentlypointing up in both direction and momentum. Finally, volatility indicators like the Average True Range (ATR) should be used to warn of impending reversals. Steady trends typically exist amidst low volatility, which is shown by a low ATR. High ATR readings can happen due to a sharp advance in the trend, but are more commonly seen during correctionsand reversals.

Breakout: In contrast, a breakout strategy is typically used on ashorter time frame. Again making sure to follow and not fight the trend (seen on a daily or weekly time frame chart), breakout trading opportunities can be found on the 60 minute (1 hour) or 240 minute (4 hour) charts. After periods of consolidation, where the price mostly moves sideways on the chart and the ATR drops, it is highly likely that the larger trend will continue with a quick break from any range that has formed. Breakout traders try to take advantage of the fast, strong movement that typically happens when the price breaks out to new highs.

Gold_Again_Near_All-Time_Highs_Whats_Next_and_How_to_Trade_It_body_Picture_8.png, Gold Again Near All-Time Highs: What’s Next and How to Trade It

When breakout trading, it is important to have clearly defined entry and exit points. Stop-loss orders should be set very tightly, so you are out of your trade very quickly if an anticipated breakout fails to occur. You should also set reasonable targets that are not too far away from the entry point. While breakouts can move very quickly and impulsively, they can often run out of steam quickly. Since it is short term, breakout trading tends to produce many trades over the days or weeks that you would hold a momentum trade. Because of this, there can be less anxiety with breakout strategies than with momentum ones; but they do require you to pay closer attention. For technical indicators, intraday levels of support and resistance are important.Breakouts occur when support or resistance is broken, so it is important to know these levels. Low volatility readings, such as a low ATR, tend to precede breakouts. You can often spot a potential breakout by looking for low volatility. The price is slowly gathering energy before the powerful explosion through support or resistance.

Where can I learn more?

To learn more about trading, market conditions, chart reading, technical indicators, and important economic news, take a look into the DailyFX+ Trading Course. The course is interactive, with multiple live sessions daily, where experienced instructors show you examples and answer your questions over the web. The course also crucially teaches money management skills, such as where to set a good stop-loss order, how large a trade to put on, and how to best get into trades. The course is free for all live FXCM account holders. You can also get a preview of the more than sixty course videos with a free course trial: Visit the DailyFX+ Trading Course

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