Module 1: Introduction to Gold Trading

1.1 What is Gold? ^[1,2]

Gold is a precious metal with several qualities that make it a valuable asset. Throughout history, it has been collected as jewellery and used as a means of exchange. And today, gold also has several modern applications across sectors including electronics, dentistry, medical tools and defence. It is also rare and difficult to extract, and only a finite supply is available – two factors that further strengthen gold’s enduring appeal. 

Historically, gold has played an important role in the modern financial system. Up until the 1930s, major currencies were pegged to gold. This was known as the gold standard, in which the physical quantity of gold acted as a limit on currency issuance, allowing economies to sidestep the perils of inflation. 

However, the gold standard soon proved to be too rigid to properly serve the needs of the global financial system. In short, the gold supply could not keep up with the speed at which economies were developing. It was also proven to be inflexible under trying economic times.

In 1971, fighting growing inflation and to prevent foreign nations from overburdening the system by redeeming their currencies for gold, US President Nixon severed the value of the US Dollar from gold. This formally ended the gold standard, moving the global financial system fully onto the fiat system. 

Nonetheless, gold remains popular among investors for several reasons. It has a proven ability to hold its value, making it a good option as a store of value and inflation hedge. The precious metal is also one of the most actively traded commodities, allowing high liquidity in the gold market. There are also several ways gold can be traded, allowing traders to deploy a variety of strategies. 

1.2 How can you trade gold? 

There are three main ways investors can trade gold, each with different levels of complexity and potential for returns. These are buying and selling physical gold, investing in gold ETFs, and trading gold derivatives such as CFDs and futures. 

For a more detailed discussion, refer to Module 2: Types of Gold Investments

Buying and selling physical gold

The most basic way to trade gold is to buy physical gold, which may come in the form of bullion, coins or jewellery. When gold prices increase, some of these physical gold holdings may be sold for capital gains. 

Note that this method of trading gold only allows potential profit when the gold market goes up. Still, gold is highly capable of providing good returns. Over the past five years in 2024, gold climbed 81.65%, beating out the S&P 500 which grew by 76.22%. ^[3] 

Trading physical gold raises issues of security, as it is generally not safe to keep large amounts of gold in your home or office. Traders can make use of storage services provided by gold bullion sellers, or rent a safe deposit box from a bank. 

Investing in gold ETFs

Traders can invest in gold funds to gain exposure to the performance of gold. 

Many gold ETFs offer exposure to the performance of gold stocks, including mining companies, or gold jewellers. There are also some gold ETFs that invest directly in the commodity, providing direct exposure to the price action of gold. 

The benefits of investing in gold ETFs include the ability to avoid holding physical gold, as well as the low expense ratios typically charged by fund managers. Also, gold ETFs are tradeable on stock exchanges, which makes such funds more liquid than physical gold. 

Trading gold derivatives such as CFDs and futures

Another way to trade the gold market is via derivatives such as Contracts for Differences (CFDs) and futures. Both do not involve direct ownership of gold or gold stocks; instead, they allow you to speculate purely on the price action of gold. 

Unlike the other two methods mentioned above, Gold CFDs and futures allow both short and long positions. This means traders can potentially profit from either direction, and not only when the market goes up. 

1.3 Why trade gold?

The profit potential and capital appreciation of gold is well documented, but those aren’t the only reasons to trade gold. Due to its unique position in the global financial system, gold trading can offer several more benefits, including diversification, inflation hedge, and acting as a safe haven. 

Diversification ^[4] 

Gold is an effective portfolio diversifier because it has been shown to have a negative correlation to equities and other risk assets, especially as the markets sell off. One example was during the Great Financial Crisis of 2008. From Dec 2007 to February 2009, while equities, real estate and most commodities dropped, gold instead made gains of around 21%. 

Inflation hedge and safe-haven asset ^[5]

Gold is also highly regarded as an inflation hedge and safe-haven asset, due to its ability to hold its value compared to the US Dollar. This is due to two factors – its many uses, and its finite supply – which ensure that gold will never lose its value for the foreseeable future. 

By contrast, the supply of the US Dollar can be increased through money printing – a step taken by the US Federal Reserve as part of economic control measures. When this takes place, the value of the Dollar is devalued, as there is more to go around. 

Gold tends to increase in price when the Dollar goes down. This means that if you have USD 1,000 in cash and USD 1,000 worth of gold, your cash will be worth less than your gold over time. By holding gold, you are hedged against the effects of a falling Dollar. 

Because gold has a proven ability to hold its value relative to other assets, investors regard gold as a safe haven asset. During weak economic cycles where equities, real estate and other commodities fall in value, many investors flock towards gold to limit their losses and ride out the downturn. 

1.4 Who trades gold?

Gold is among the most widely traded assets on the market and is traded by everyone from retail investors to institutions and central banks. 

Retail investors and speculators

Retail investors may buy and hold gold for exposure to the commodity itself, or invest in gold ETFs to gain wider exposure to the gold sector, including producers and sellers. Meanwhile, speculators trade in gold CFDs or futures to speculate on the price action of the gold market. 

Institutional investors 

Institutional investors such as banks, pension funds, hedge funds, insurance companies and credit unions may also invest in gold. According to research by the World Gold Council, institutional investors trade gold primarily for inflation hedging and portfolio diversification ^[6].

Central banks ^[7]

Gold acts as an important portion of central bank reserves due to its safety, liquidity and proven ability as a long-term source of return. Central banks are significant holders of gold, accounting for around 20% of all gold that hasd been mined throughout history. 

In 2022 and 2023, central banks stepped up gold buying to around 1,000t per year. This trend is set to continue; in 2024, central banks net demand for gold totalled 290t in Q1 – the strongest start to any year on record.

1.5 Major gold markets 

Generally, gold is traded via these major markets – spot market, gold ETFs, and gold futures. 

Spot market

Gold may be traded on the spot market at the current live price (spot price) of the commodity itself. The most basic example is visiting a gold dealer to purchase a certain amount of gold at the spot price. You can also sell your gold holdings at the spot price to cash out, or make a capital gain (if the selling price is higher than the price at which you bought your gold). 

Gold trading on the spot market can also be carried out via an online broker, although you may need to check for storage fees. Afterall, gold is a commodity, and when you purchase a commodity you’re expected to take delivery.

Gold ETFs

Gold ETFs offer a variety of ways to invest in gold, such as by tracking the spot price of gold, or by gaining exposure to the stock performance of gold producers and sellers. 

Gold ETFs that track gold prices allow investors to benefit from capital appreciation when gold goes up, without having to manage physical holdings of gold. This is a more convenient approach for those who do not want to deal in physical gold. 

Meanwhile, gold ETFs that track the performance of gold stocks offer another way to invest in gold. Because the performance of gold-related companies are often tied to gold prices, their stocks also tend to move in tandem with the gold market. 

Gold futures

Futures contracts are derivatives that are used to hedge against volatility in gold. 

In a gold futures contract, two parties agree to trade gold at an agreed price and quantity, but the trade is only settled on a future date. From a hedging perspective, this helps to prevent negative impacts from price spikes or crashes. 

Gold futures are also traded for the purposes of speculation. Traders can take long or short positions, and stand to potentially profit if the price of gold moves in their favour. As gold futures are traded on exchanges, they enjoy higher liquidity and reliability. Futures contracts can also be traded on leverage, allowing higher capital efficiency. 

1.6 Understanding gold prices ^[8]

There are several factors that drive the price of gold. These include jewellery and industrial demand, central banks, investment demand, production levels, and the strength of the US Dollar. Let’s take a closer look at these in turn. 

Jewellery and industrial demand

The gold jewellery sector accounts for around 44% of global gold demand, with technology and industrial demand making up another 7.5%. 

This means that gold and industrial demand together account for around 50% of global gold demand. As such, an increase in demand from these sectors can drive gold prices higher. 

It’s worth noting that during economic downturns, demand for gold jewellery increases as more people seek to preserve their wealth by exchanging cash for gold. Thus, poor economic performance can also drive up the price of gold via gold jewellery demand.

Central banks

As noted earlier, central banks are significant holders of gold, holding around 20% of all gold mined to date. This makes demand from central banks a major driver of gold prices.

When gold demand from central banks increases, gold prices tend to go up – as can be seen in Q1 2024 when record-levels of gold buying from central banks coincided with a gold price rally ^[9]. 

Investment demand 

Due to its status as an inflation hedge and safe-haven asset, investment demand for gold tends to increase during times of economic weakness or political instability. Investors seeking to limit losses from high inflation exchange cash for gold, createing increased demand that can drive gold prices up.

Another factor is its negative correlation with the stock market. When equities drop, gold prices tend to hold their levels or even increase. This, again, increases investment demand for gold, contributing to gold price increases. 

Production levels

As gold is a commodity with a finite quantity in circulation, its price is also sensitive to production levels. High gold production levels increase circulating gold supply, which may have a cooling effect on gold prices.

In contrast, when gold production levels fall, the supply of gold in the market shrinks. This can lead to a supply squeeze which drives gold prices up. 

Strength of the US Dollar

Gold is denominated in the US Dollar, causing the two to share an inverse relationship. In short, when the US Dollar weakens, demand – and therefore, prices – for gold tend to increase, especially among holders of other currencies. This is because more gold can be bought when the US Dollar is weaker.

Conversely, when the price of the Dollar strengthens, the gold prices are seen to be more muted and controlled. 

1.7 Common jargon in gold trading ^[10]

Allocated gold

Gold bullion that belongs to the owner outright, is stored in a professional vault. Allocated gold bullion is the property of the owner, and is held in custody on their behalf. 

Bailment

Refers to a legal relationship where physical possession of gold is transferred from one person (the ‘bailor’) to another person (the ‘bailee’) who subsequently has possession of the property. Bailment occurs purely for safekeeping purposes, and does not transfer ownership rights. 

Caratage

The measure of purity of gold alloyed with other metals. 24 carat is pure gold with no other metals. Lower caratages contain less gold; 18 -carat gold contains 75 per cent gold and 25 per cent other metals, often copper or silver. Note that the minimum caratage to be called gold varies by country. 

Doré

A mixture of unrefined gold and silver was, produced at the mine to make shipment cheaper. 

Fineness

A measure used for investment gold. The minimum fineness specified for delivery is 995 fine (pure gold content of 995 parts per thousand), although bullion coins for retail investors are typically 999 fine, as are kilobars for the Chinese investment market. 

Kilobar

Investment-grade gold bars weighing 1 kilogram each. Available in 995 or 999 fineness. Gold kilobars are preferred in China and India. 

Paper gold

May refer to gold options or futures contracts, or investment products which are related to gold prices, but without any physical ownership.

Module recap

• Gold is a precious metal, an important commodity and a highly sought-after asset. It has unique qualities that make it stand out from other types of investments. 
  
• Besides offering potential capital appreciation, gold is also capable of acting as a safe-haven asset, and to hedge against inflation. These two qualities render gold a capable store of value. 
  
• Another reason to trade gold is its capability for diversification due to its negative correlation with the stock markets.
  
• Common ways of trading gold include buying and selling physical gold, trading gold CFDs and futures contracts, and investing in gold ETFs.
  
• The precious metal is traded by retail investors and gold speculators; institutional investors such as pension funds and hedge funds; and central banks. 
  
• Of late, central banks have been increasing gold buying activity, purchasing more than 1,000t of gold in 2022 and 2023 each. This trend continues with record levels of gold purchases by central banks in Q1 2024, coinciding with a rally in gold prices.
  
• Gold may be traded on the spot market, via futures contracts, or through gold investment funds. 
  
• The major drivers of gold prices are:
  
  – Jewellery and industrial demand, which together account for nearly 50% of global gold demand
  
  – Central bank demand. Gold represents a significant proportion of central bank reserves.
  
  – Investment demand. This can stem from various reasons, such as the desire to preserve wealth against high inflation, or to ride out market instability.
  
  – Gold production levels. The finite nature of physical gold means price fluctuates along with production levels.
  
  – US Dollar strength. When the US Dollar weakens, gold demand (and prices) tend to rise, and vice versa. This is because gold is denominated in the Dollar. 

Module recap

• Gold’s value is known for its rarity and stability, gold is valued as a store of wealth and industrial resource.
  
• Once central under the gold standard, gold remains a favoured asset for hedging and wealth preservation. 
  
• Investors can trade gold via physical assets, ETFs or derivatives like CFDs and futures. 
  
• Physical gold offers direct ownership, while paper gold (ETFs, derivatives), allows easier access and liquidity. 
  
• Gold provides capital appreciation, portfolio diversification and a safe-haven during economic downturns. 
  
• Gold retains value amid economic turbulence, appealing to investors as a low-risk asset. 
  
• Gold prices are driven by demand (jewellery, investment), central bank purchases and the US dollar’s strength. 
  
• Essential terms include “allocated gold” (stored, owned, outright) and “caratage” (purity measure).

References

1. “Why Has Gold Always Been Valuable? – Investopedia”. https://www.investopedia.com/articles/investing/071114/why-gold-has-always-had-value.asp.
2. “What Is The Gold Standard? Advantages, Alternatives, And History – Investopedia”. https://www.investopedia.com/ask/answers/09/gold-standard.asp.
3. “Gold vs. S&P 500: Which Has Grown More Over Five Years? – Visual Capitalist”. https://www.visualcapitalist.com/gold-vs-sp-500-which-has-grown-more-over-five-years/.
4. “Gold As A Strategic Asset: 2024 Edition – World Gold Council”. https://www.gold.org/goldhub/research/relevance-of-gold-as-a-strategic-asset/golds-key-attributes-2-diversification.
5. “What Is An Inflation Hedge? – Investopedia”.  https://www.investopedia.com/terms/i/inflation-hedge.asp.
6. “The Use Of Gold In Institutional Portfolios – World Gold Council”. https://www.gold.org/goldhub/research/use-gold-institutional-portfolios.
7. “Gold Demand Trends Q1 2024 – World Gold Council”. https://www.gold.org/goldhub/research/gold-demand-trends/gold-demand-trends-q1-2024/central-banks. Accessed 12 November 2024.
8. “What Drives The Price Of Gold? – Investopedia”. https://www.investopedia.com/financial-edge/0311/what-drives-the-price-of-gold.aspx.
9. “1-year Gold Price – Gold Price”. https://goldprice.org/.
10. “Gold Glossary – Bullion Vault”. https://www.bullionvault.com/gold-guide/gold-glossary/.