Understanding the gold market

Understanding the gold market can be a useful tool in picking the right time to buy or to sell. The 'gold market’ is an international digital network of gold trading. There are two types of trading: physical and ETFs - Exchange Traded Funds.

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Physical Gold

In the case of physical gold, actual bullion changes hands between the buyer and the seller. Gold from mines, or scrap gold, is sent to a refiner or a mint for smelting. The precious gold is then turned into an ingot or a coin. Most gold bullion is 999.9 purity, but on occasion products can be less - such as the 22 carat gold Sovereign or gold Krugerrand coins.

Physical gold can range from small purchases for individual investors, to huge bulk purchases by nations for their gold reserves. Periods of high demand and/or low supply can help drive the gold price higher, with the inverse also being true.

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Gold ETF

Gold ETFs make up the other side of the gold market and are very different. No p hysical gold changes hands with an ETF. Instead, contracts or future options (to buy and sell at a chosen time and prices) are traded. The traded contracts and options or 'futures' refer to physical gold which is held by accredited warehouses, refiners or mining companies but is rarely actually delivered.

Gold ETFs are primarily used by traders rather than investors, and represent huge amounts of potential gold. ETFs will often drive the gold price up and down much more quickly than physical gold.

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Circle of integrity

Once gold enters into the cycle of accredited refiners and warehouses, called the 'circle of integrity', traders can deal in contracts and options. The supply and demand of contracts and options on the gold market determines the market price of gold.

In addition to supplying the accredited warehouses such as Brinks, HSBC, and JP Morgan Chase, accredited refiners and mints sell out of the cycle to jewellers, manufacturers and bullion dealers. This gold leaves the circle of integrity and can be used by industry, mixed with other metals for jewellery, or sold as investment gold in the form of bars or coins by bullion dealers. The price of this gold is still be determined by trade in contracts or options on the international markets.

The gold price paid by investors is therefore the market price plus the cost of refining into bars and coins, handling, transport and premiums from dealers.

As well as selling gold, refiners and bullion dealers will buy back physical gold, which is then sold on to approved refiners and re-enters the circle of integrity, ready to be traded again on the international markets.

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Commodity

Gold is considered a commodity like oil and fuels, livestock and meat plus agricultural products such as wheat, coffee and sugar. Commodities markets differ from other markets in that the products are all identical. In other stock markets producers set their prices, charging premiums for better products or under cutting competitors by producing more basic products. In contrast, producers in commodity markets, make identical products, and must sell at the market price as determined by supply and demand.

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Gold Options

Dealers on the gold markets trade in contracts and options. A contract is a certificate of ownership whereby the holder or keeper of the physical gold - usually an accredited warehouse, refiner or mine - guarantees to deliver to the owner. An option or futures contract is an agreement to buy at a set price in the future.

Buyers of such options hope that the market price will, at the set time, be higher than the agreed price. This is called a 'long' option.

Sellers hope that the market price will, at the set time, be below than the agree price. This is called a 'short' option.

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Gold Futures

Futures options are used to bring some degree of stability to volatile commodity markets.

As an over-simplified example: If a manufacturer needs 100 ounces of gold to make 400 rings, they can hedge their risk over the time it takes them to make and sell the rings. They do this by buying the physical metal and, at the same time, buying future options on the same amount of gold. When he sells his rings, based on the market price at the time, he can buy back his options and cover his risk.

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Five gold market realities

1. Gold is a long-term investment. Short-term market volatility does not equal risk as the long-term trend is stable.
2. Short-term gold prices move to balance supply and demand within the market.
3. Contracts, futures or exchange funds cannot satisfy the demand for physical gold.
4. The United States economy is the major influence on the gold price. Generally, the stronger the US economy and US stocks, the lower the gold price. USD is seen as a safe haven akin to the Japanese Yen, so a falling US Dollar generally increases gold demand.
5. Major trends in the US Dollars gold price is determined by the level of confidence in the US economy. These trends are not affected by, mining and scrap supplies, buying or selling by central banks or imports of gold into the US.

Gold has traditionally been viewed as a safe haven investment in times of failing markets and, due to its price movements being uncorrelated to other stocks, it makes a useful hedge against other investments and good means to diversify an investment portfolio.