Gold (Part 2)

8.1 – The London fix

In the previous chapter, we discussed the various Gold contracts that are available on MCX. I want to begin this chapter by discussing how the prices of Gold in the spot market are arrived at internationally and in India.  However, I have to mention this – this method to ‘fix’ gold prices is merely symbolic and holds very little relevance to trading gold futures at MCX. I’m discussing this simply because it is an interesting thing to know. J

Internationally, the price of Gold is fixed in London daily, twice a day in two different sessions. The morning session at 10:30 AM is referred to as ‘AM Fix’ and the evening session at 3:00 PM is called the ‘PM Fix’. The prices are fixed by the gold dealers from London’s biggest bullion desk. The whole process is facilitated by Nathan Mayer Rothschild & Sons.

There are about 10-11 participating banks, which include names like JP Morgan, Standard Chartered, ScotiaMocatta (Scotiabank), Société Générale etc.  Do note, the general public and other banks are not permitted to participate in this process. The dealers from these banks call the dedicated conference line at the designated time and submit their bids to buy and sell gold. From all the bids and offers an average price is arrived at, and the same price is relayed to the market, which then becomes the benchmark for gold trading. The whole process lasts for about 10-15 minutes. The process is again repeated in the ‘PM session’, and the gold prices are again discovered and relayed to the markets.

The gold price that is fixed by the AM and PM sessions is very close to the actual price of gold that is traded in London and other international markets. So in a sense, the price that is relayed holds no surprise to traders or bullion dealers, in fact, some participants even believe that like many things in England, even this is conducted more to keep up with tradition.

India too follows a somewhat similar practice, but less elaborate. India, being one of the biggest consumers of Gold, imports the yellow metal. The gold is imported by designated banks and the banks in turn supply this gold to bullion dealers (after adding the necessary charges; more on this a little later). The Indian Bullion Association then bids for the gold through its network of bullion dealers. These dealers mainly base their quotes on how much gold they would like to buy or sell at a given price, the rates are averaged out, and this roughly sets the floor for the Gold prices in India. In fact, there is some circularity here because dealers tend to look at the Gold futures price traded on MCX before placing their bids with the Indian bullion association. Anyway, this price is relayed to the dealers’ and jewellers’ network, and the price for the day is set.

8.2 – Gold price disparity

Traders tend to compare the Gold futures rate in Chicago Mercantile Exchange (CME) and the Gold Futures rate on MCX and assume there is an arbitrage opportunity lurking around. The rationale for this is that Gold being an international commodity should often trade at around the same price, in the absence of which an arbitrage opportunity arises. So for example, if 10 grams of 995 purity Gold in CME is quoted at $430, then on MCX the price of 10 grams of 995 purity should be in and around $ 430.

But this is often not the case, they trade at a significantly different price, and due to this a disparity between gold futures in CME and MCX always exists. The question however is, why does this disparity between the two gold futures contracts exist?

Let us figure this out –

To understand the disparity between the two futures contracts, one should understand how the Gold spot rate evolves in India.

Remember, India is a net importer of gold. In the international markets, US especially, Gold is quoted on a per troy ounce basis. One troy ounce is approximately 31.1035 grams. Assume Gold in the US spot market is traded at $1320 per troy ounce – given this, what do you think should be the spot price of gold in India. Assume $ 1 = Rs 65.

The general tendency is to identify the cost for 10 gram of gold in USD and multiply the same with the current USD INR rate and figure out the price. Let us do this math quickly –

31.1 Grams = $1320, therefore 10 grams = $424.43. Since USD INR is at 65, the price of Gold in India should be approximate = Rs.27,588/-.

Unfortunately, in reality, this is not so straightforward. Gold when imported (remember it is the banks which import gold) attracts duties and taxes. The spot price of Gold in India should include all these charges. In fact, let me list down all the costs that are applicable when a bank imports gold –

1. CIF applicable in Dollars (CIF stands for cost, insurance, and freight)
2. Custom duty
3. Cess
4. Bank cost

With all these charges, the landed price of Gold tends to increase. In fact, beautifully illustrates how the cost adds up.

So for example, if the rate of spot Gold in the US is $420 per 10 grams, then in India after adding all the additional costs, the spot rate will be much higher. For the sake of this discussion, let us assume the rate in India is $435 – leading to a $15 disparity in spot rates.

Now, this explains the disparity in spot rates, but what about the futures price? Remember the futures prices is a derived from spot rates, the formula linking futures price with spot price is –

F = S*e(rt)

You can read more on futures.

So in the US markets, the basis for the future pricing will be the spot price of Gold in the US, i.e. $420, while at the same time the basis for the future price in India will be the spot price of gold in India, i.e. $435. Given this, naturally, the futures price of gold in CME and MCX will differ. This difference should not be mistaken for an arbitrage opportunity.

8.3 – What drives the gold price?

Investors across the world have this strange, but predictable behaviour – at times of uncertainties, well at least economic uncertainties, they are all in a hurry to buy gold. Gold has always been considered a haven capable of safeguarding investments against any economic meltdown.

There was a clear run-up in Gold before the event and post the event, in fact, the big candle that you see during this period is on 24th June, the day after the Brexit verdict was out. Naturally, gold rallied owing to the outcome of Brexit. In fact, every time there is any global/domestic uncertainty, investors flock to buy gold. This is mainly driven by the fact that Gold is considered a haven, capable of preserving your wealth.

Almost all the major events in the past have had an impact on Gold, think about it – Oil crisis, middle eastern uprising, Israel-Palestine, EU migrant crisis, Greek economy, Euro crisis, Lehman Brothers; the list is never-ending. But the point to note is that every world event impacts the prices of gold.

This leads us to an important conclusion – Gold tends to increase in value in the backdrop of economic uncertainties. In fact, in the backdrop of economic uncertainties, demand for risky assets such as equities goes down, and the demand for safe-haven assets such as Gold tends to increase.

Now besides the uncertain events, even on a day to day basis, investors tend to buy gold considering it a safe hedge against inflation. They believe, in the long run, the value of gold will continue to rise. 

Take a look at the chart above, in 1970 Gold was at roughly $35 and today in 2016, Gold is at $1360, translating to a 37x return. However, when you look at it from a CARG perspective, this translates to about 8% year on year growth. The world average inflation is roughly between 5-6%. This means if you are an investor in gold, on the one hand, you are expected to make 8%, and on the other, you lose about 6% (owing to inflation) netting you with an outperformance of 2%. However, in countries such as India where inflation is high, investment in Gold does not really fetch much.

8.4 – Gold, Dollar, Rupee, and Interest rates

The movement in gold is also related to how the currencies and interest rate of the economy moves. So if you are a trader in Gold, then it is not only important to keep track of world economics, but also important to keep track of currencies and interest rates. The equations are simple; let us start with the dollar and build on it.

This is the graph of USD versus Gold. The inverse relation between the two is quite evident. This inverse relation can broadly be attributed to two reasons –

1. When the dollar decreases in values concerning another currency, then the value of the other currency increases. With the increase in the currency value, the demand for commodities, including Gold tends to increase. As the demand for gold increases, the prices too tend to increase.
2. A falling US dollar becomes less attractive to investors; the investors tend to look at parking their money in safer havens such as gold.

Having said this, one should be aware that this may not always be true. There could be instances when both gold and USD tends to increase. For example, think about a crisis in Saudi Arabia (declining oil prices), domestic investors may want to move away from investments in Saudi and park it in safer assets such as Gold and USD, thereby increasing the value of both these assets.

Either way, it must be clear to you now that USD has a role to play in the directional movement of Gold. Having said, one must study the correlations between various variables and gold to see if any correlations actually exist. For example, an increase in the US federal rates tends to strengthen the US Dollar. Under this Gold, price should reduce. But this does not necessarily happen all the time, and if I’m right, the correlation between Gold and Federal rates is just under 0.3.

I understand the discussion above is counter-intuitive, as in earlier I mentioned a strong dollar tends to push gold prices down. Still, the factors that influence USD may not actually have a strong bearing on Gold itself.

Confusing? Yes, it is, I agree.

So how would one actually trade gold? One of the best ways to trade gold is by studying its demand and supply. Demand and supply factors are many and complex, especially for an international commodity such as Gold. However, the demand and supply pressures reflect themselves in prices and a sense manifest themselves in the form of charts, and charts can be read using ‘Technical Analysis’, and this is how you can develop trading insights in gold.

I’m a huge fan of Fundamental Analysis when it comes equities, but when it comes to commodities and currencies, I resort to charts.

8.5 – Technical Analysis of Gold

If you are not familiar with Technical Analysis (TA), then I’d suggest you read the module.

One of the key attributes of TA is that TA can be applied to any asset class, including currencies and commodities. Let me develop some trading notes on Gold by employing TA. Hopefully, this will give you a sense of how to apply TA on Gold.

When I trade Gold, the objective is obvious – it is a short term trade, and there are no intentions to carry the trade for say more than a few days.

The very first thing that I do when developing a trading view is to look at the long term chart of the asset; by long term, I mean at least 2 years. I’ll do the same here; I’ll look at the end of day Gold Bees (ETF) chart for this. Do note, and I will use this chart to develop a rough idea on the primary trend of Gold and also observe critical price points if any.

From the chart above, I note the following points –

1. Gold declined to start from late 2013, all the way to late 2015.
2. Prices bottomed over the last few months of 2015.
3. Gold in fact formed a double bottom between Sept-Dec 2015.
4. Prices have been trending up since early 2016.
5. Traders have bought Gold at every decline starting from early 2016.
6. Clearly, the bearishness in gold is no longer there, and this is evident given the fact that gold has scaled back to 2013 prices.

With all this, I can conclude that I’d be more comfortable with long trades than short, but this does not mean that I will not short Gold. I would if the risk to reward is enticing enough. However, if I short Gold, I will always be aware that traders out there are looking for opportunities to buy gold at every dip; hence I will be quick to cover my short position. I was hoping you could do note, until this stage, I have only developed a broad-based view on Gold and have not ventured into any specific price levels.

I would now be interested in looking at a short term chart of Gold, in identifying trading opportunities if any. Please have a look at the chart below, before we get into identifying trading opportunities (for which we will have to look at the right side of the chart), let’s spend a little time on the left side of the chart.

The starting point of this chart is sometime in late 2015, and till about the end of June 2016; there is pretty much no activity. This is evident when you look at both the price and volume. The volume is almost non-existent, and the prices tend to gap up and down. Can you guess why?

Well, remember Gold contracts are introduced almost a year in advance, for example, the Oct 2016 contract (which we are looking at), would have been introduced around Oct 2015. However, this contract does not attract any liquidity till it nears its actual expiry, i.e. October 2016. If on the other hand, our markets were very vibrant with lots of liquidity, then probably this contract would have attracted liquidity much earlier.

Anyway, let us now look into the left side of the chart and identify trading opportunities if any. I’ll repost the chart emphasizing the recent candles; I have overlaid 9 and 21-day exponential moving averages on the prices –

1. The current market price is below both the short term averages.
2. There are three price action zones in the recent past at around 30956 (I’ve encircled the same in blue circles), and since the current market price is below this level, 30956 becomes an immediate resistance.
3. In the recent past, we can see a Bearish Marubuzo formed (circled in black), which has played out well. Traders may be booking profits on this one.

Considering all the above, I would be looking at buying opportunities in Gold, the moment it crosses the resistance level of 30956. Notice, this also coincides with the two short term moving averages, which further encourages me to go long. However, if the price of gold stays below the resistance level, I would hesitate to short for reasons we discussed earlier. So, in summary, my trade would be something like this –

• Position: Long
• Price: Above 30956
• Target: 31418 (have placed a short blue line)
• Stoploss: 30700 (current market price)
• Reward to risk assuming I’m going long at 30956: 1.8
• % move from entry – 1.5%

Not a bad trade from a reward to risk perspective I’d think. Also, since we are looking a 1.5% move, this may pretty much happen in a single day.

Anyway, the whole point here is to elaborately explain to you that TA can easily be applied to commodities such as Gold.

I hope the last two chapters have given you enough information on Gold, this, in my opinion, is put you in a good spot to get started in trading Gold.

Onwards to Silver!

Key takeaways from this chapter

1. The price of Gold if fixed twice a day in the AM & PM session in London
2. Only designated banks can participate in the London fix.
3. India too has a gold fix, similar to London fix – however, there is some circularity here as traders tend to look at the prices of MCX.
4. The spot price of gold in US and India differs mainly owing to the additions duties, taxes, and charges that get added in India.
5. Since spot prices vary, so does futures price.
6. Dollar and Gold are inversely related.
7. Commodity fundamentals are complex to understand. Hence traders tend to look at demand and supply.
8. Demand & supply reflects in the current price, and also manifests itself in charts.
9. You can apply technical analysis on Gold and other commodities