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Understanding the Gold Market’s Structure

June 08
16:52 2011

Gold is unlike any other market … because its buyers and sellers are unlike those for any other stock, bond, commodity, or currency. If you are thinking about starting to trade gold, it’s helpful to get a firm grasp on who else is involved and what motivates them.

To put this idea in terms which might already be familiar, think about the trading that goes on for a particular stock. Investors buy relatively more of that stock and with greater enthusiasm whenever they feel the underlying business is creating more value and will benefit its shareholders more in the future, if only by further rises in its stock price. As a result, the stock price goes up. If investors hold the opposite expectation, they sell more and with greater urgency, and the stock price goes down. But the overall price of the asset is tied to ideas of the value created by the company. Bonds are traded with similar ideas of their underlying value.

Well gold, on the other hand, is a mineral. It doesn’t change over time or create value in any way; it just sits there like the static substance it is, so traders in the gold market can’t rely on any calculations of gold’s underlying value. That description may make it start to sound like a commodity, and it is. Gold futures contracts, the financial trading instrument used to access the gold market, represent a standard sample of 100 troy ounces of gold which assays to a minimum of 995 fineness (a grading specification), and each sample is by definition interchangeable with any other sample. However, gold traders can’t effectively use the same analysis techniques they might use with other commodities because except for a limited amount of industrial usages, gold isn’t really subject to supply and demand in the same ways that cotton, orange juice, and pork bellies are.

Actually, new sources of supply can be measured and analyzed as gold is mined from the earth, but as far as demand goes, gold “consumers” really just seek out the substance to hold as a financial instrument: a substitute for a certain amount of cash. They do so because they feel gold will hold onto its value as money with more stability than any one country’s legal tender, and that makes it an especially popular investment during a recession or time of political upheaval.

Now gold trading is starting to sound more like currency trading, which is accurate … to a point. Holding gold as a substitute for currency explains the motivations of a large chunk of the gold market, but as far as active trading goes, using currency analysis techniques on gold will generally fail because gold doesn’t represent an underlying country or economy. There’s no one making decisions on gold’s “interest rate” or influencing its GDP.

So your best bet for understanding the structure of the gold market is to understand the motivations of the people who invest in gold – financial or political risk aversion, portfolio diversification, substitution for currency, and even industrial supply and demand – and then be able to anticipate changes in their sentiments.

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