Module 8 Currency, Commodity, and Government Securities

Chapter 8

Gold (Part 2)

50

M8-C8-cartoon

8.1 – The London fix

In the previous chapter we discussed the various Gold contracts that are available on MCX. I’d like 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 on a daily basis, 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 sort of 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 jewelers’ 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 future contracts exist?

Let us figure this out –

To understand the disparity between the two future 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 approximately = 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, this post on TradingQ&A beautifully illustrates how the cost adds up.

So for example if the rate of spot Gold in 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 pricing.

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 behavior – at times of uncertainties, well at least economic uncertainties, they are all in a hurry to buy gold. Gold has always been considered a safe haven capable of safeguarding investments against any sort of economic meltdown.

Consider the Brexit (June 2016) event, the most recent event which kind of shook the world, and here is how Gold behaved before and after the event –

Image 1_Gold brexit

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, each and every time there is any sort of global/domestic uncertainty, investors flock to buy gold. This is mainly driven by the fact that Gold is considered a safe haven, capable of preserving your wealth.

Almost all the major events in the past has 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. This perception is justified if you look at a very long term chart of gold –

Image 2_long term gold

Source: http://www.lbma.org.uk/pricing-and-statistics

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 one hand you are expected to make 8% and on the other you lose about 6% (owing to inflation) netting you with an out performance 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.

Have a look at this graph below –

Image 3_Gold vs $

Source: https://fred.stlouisfed.org/graph/?g=33vD

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

  1. When the dollar decreases in values with respect to 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 ways, 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, increase in the US federal rates tends to strengthen the US Dollar, by virtue of 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 kind of counter intuitive, as in earlier I mentioned a strong dollar tends to push gold prices down, but 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 in a sense manifest themselves in the form of charts, and charts can be read by means of ‘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 on Gold

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

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 very clear – it is a short term trade and there are no intentions to carry the trade for say more than 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, I will use this chart to develop a rough idea on the primary trend of Gold and also observe critical price points, if any.

Image 4_Gold ETF

From the chart above, I note the following points –

  1. Gold declined starting from late 2013, all the way to late 2015.
  2. Prices kind of 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, 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. 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, to identify trading opportunities if any. Have a look at the chart below, before we get into indentifying 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.

Image 5_Gold illiquid

The starting point of this chart is sometime in the late 2015, and till about 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 just 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 –

Image 6_Goldlong term

  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 according to me 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 sort of circularity here as traders tend to look at the prices of MCX
  4. 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

50 comments

  1. sandesh says:

    pls include a topic on how to make profit by hedging commodities. Tx

  2. MSP says:

    Hi Karthik,
    Gold bee charts : from where we can get these ?
    Regards,
    Madhusudan

  3. Rajat Sharma says:

    Which timeframe should be used to trade gold for short term trading

  4. Pavan says:

    Dear Karthik.
    I want to analyse the EOD Gold charts for last 2 years. But if I go to the latest contract in Gold on PI or Kite, I cannot get the historical data. The workaround to study the trend is to use Goldbees . But there is no such ETF in case of Crudeoil.
    1) Where can I get the historical data time series (continuous futures) for Gold with price shown in INR ?
    2) If I have last few contracts data, how can I create a continuous time series data with this ?
    Thank You.

  5. Priyank Saxena says:

    Sir is there anyway to get 10 or 15 min. IEOD data for past 6 months of gold, as to backtest my strategy on Pi.

  6. Keshav says:

    Sir we are waiting for next chapter..

    • Karthik Rangappa says:

      Next chapter on Silver will be delayed a bit, maybe 1st week on Oct. Couple of things have come up, which I need to finish before I can put up the chapter on Silver. Thanks for you patience.

  7. Manoj Chakraborty says:

    Appreciate your efforts in explaining the markets in such a easy to grasp way. Varsity is by far the best as far as understanding the markets and its technicalities is concerned. Sir, with the introduction of options in commodities recently, will you please include a topic on the same? Thanks.

  8. Avinash Pawde says:

    Hello sir, please let me know about trading with use of Excel sheets.. I have no idea about this tool so pls suggest me if any module u covered on this or where i can get knowledge about this. Thanks.

  9. Khyati Verdhan says:

    Sir, very much thank you for this chapter.
    Sir in the last chart price is below the line joining three price points and acts as a resistance to price, the price is below the resistance line then why not we short rather than waiting for price to cross line to go long.
    Please explain this.

  10. Param says:

    New chapter >.< we want new chapter

  11. Ajay says:

    Dear Sir,
    I would like to thank you for effort you have put in to teach us here. It is great sir. Hats off to you.
    Sir we will be more glad if you put these lesson in Video form if possible. Thanks a ton in advance

    • Karthik Rangappa says:

      Thanks for the kind words Ajay. Videos take in a lot more efforts and bandwidth, something we cannot afford at this stage. You will have to make do with this format for now 🙂

  12. krishna.k says:

    Hi Karthik,
    what is meant by gold bees(ETF)
    Thanks&Regards

    • Karthik Rangappa says:

      It is an Exchange Traded Fund (ETF), whose value depends upon the price of Gold’s spot price. In fact all ETF;s have and underlying theme, whose value depends upon the price of underlying.

  13. Aditya says:

    Hi sir,
    I want to know about the factor which effect the gold prices specific to indian market?
    There was a news regarding option feature in gold trading? Do you know from when it will start?
    Thanks in advance

    • Karthik Rangappa says:

      No options on commodities yet. Gold is an international commodity, hence its prices depend on international demand supply dynamics.

  14. DEEPESH KUMAR says:

    Why this module is not available for download like other modules?

  15. Saida Rao says:

    Hi Karthik,

    1. Why the prices are different for GOLD and GOLDMini contracts for same expiry?
    2. Why Goldpetal prices are too much different from GOLD?
    3. Why Goldpetal roll over premium is so low comparing to GoldMini?

    • Karthik Rangappa says:

      1) Attributable to demand and supply
      2) Same underlying, different contract sizes
      3) Not sure, need to check this.

  16. Virochan says:

    Again excellent effort towards spreading knowledge on commodity part as well ……. this is a great thing from you and team zerodha …..though I am trading commodity since more than a year … now able to understand and relate mistakes have done in past …….
    just one request …. as kite or pi dont have base commodity charts ( like default nifty50 ) but have only futures charts resulting unable to see long term charts of commodities , is there any plan of adding base prices in terms of charts ?

    • Karthik Rangappa says:

      If the spot rates are available with MCX, then we would be able to show it on Kite. By the way, we do have Nifty 50 spot chart on Kite.

      • Ananth S H says:

        Hi Karthik

        Where else can we obtain chart of historical spot prices of commodities …. I would like to see long term price chart of spot prices of metals like gold, silver etc. for the purpose of technical analysis ….. Could you pls suggest a source ….

  17. jagdeep says:

    hi, i want to know that if i have different arbitrage ideas with different exchanges in the world, do you provide me the account for arbitrage ??

  18. Pramod Kumar says:

    Hi Karthik,

    I wanted to check on TA that in case of commodities or currencies, only candlestick patterns come in use, not the S&R or other indicators. I believe so. What are your views?

    • Karthik Rangappa says:

      All TA techniques are applicable to assets which have organised time series data like stocks, currencies, and commodities. This is also applicable across all time frames – intraday, daily, weekly etc.

  19. Ajax Titan says:

    What is the procedure to take physical delivery of gold ? I have read somewhere to contact one’s own broker to request him to take physical delivery. Is it true? Please suggest solution for physical delivery of gold of a contract purchased on MCX.

    • Karthik Rangappa says:

      We do not support physical delivery of any Commodities. Usually, the process involves you to intimate your broker about this and carrying forward the contract to expiry.

  20. ashok bhide says:

    why we dont have dmat trading form like equities in gold contracts? i dont understand the reason. paying full margin/value and holding co like ETF in gold is the requirement. please explain?

    • Karthik Rangappa says:

      ETF is like a share, Ashok. Just like the way you pay full cash while paying for a share, you pay full cash for ETF.

  21. Pardeep kumar says:

    can i carry forward my position in gold till next expiry date. If i want to invest in gold for 6 months to one year, what is the option? is there enough liquidity in Gold ETF’s.

  22. Pardeep Kumar says:

    If I am a long term investor with time horizon of 5 to 10 years and I want to protect my assets during bear market than in case of nifty 50, when 50 SMA crosses below 200 SMA I sell all my securities and invest in gold etf until 50 SMA again comes above the 200 SMA. Is it a good strategy sir?

    • Karthik Rangappa says:

      Yes, however, if you are a truly long-term, then I guess this exercise is not required. I’d suggest you invest and forget about it. But do make sure you are investing in a solid business.

  23. Priya says:

    Are the Gold and Silver contracts that have been made available in NSE and BSE tradable in Zerodha. I am unable to add them to watch list. thx

  24. Vibhore says:

    Are covered calls possible with Gold futures and options? Is there any catch to it?

    • Karthik Rangappa says:

      Hmm, I’m not sure Vibhore. You will have to buy futures and sell the OTM options I guess. Will check the technicalities.

  25. Vibhore says:

    Hi Karthik,

    That’s what I am trying to understand “the technicalities”, Are there any restrictions imposed by exchange about this? Gold has physical delivery model I believe, Could that affect it in any way? Are there any other gotchas like this to watch out? I am looking for information about Gold/Crude Oil/USDINR on the same topic if you could help out. Most importantly Margin Calculator for Gold options is not working, it doesn’t show the margin required, Can you please check that too?

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