Gold and Silver Trading Theory: Fundamental Analysis And Technical Analysis

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Exploring The Framework That Defines Commodities Investing, Considering Market Psychology

Precious metals investors are a breed apart from most other types of investors for one simple reason: when precious metals investors enter commodities markets with the intention of holding physical assets, those investors are on their own in the sense that once their investment is made, once they purchase and take delivery of physical commodities, they essentially become their own financial advisors. As where people who purchase stocks or bonds usually rely on brokers to manage their investments, physical commodities investors, by default, are responsible for managing their own accounts.

The following information offers a simple framework that is meant to help new investors understand how commodities markets operate. There are many, many similar online resources that offer guidance on the same subject matter. Clicking on individual dealer links that appear on this site's homepage reveals a host of additional educational resources. As a new investor, gaining exposure to many different trading (buying and selling) perspectives should be priority number one.

Over time, one of the most important realizations all new investors inevitably come to is the fact that there are no straight forward, sure-fire investment strategies. If there were, this site and most sites like it would have no reason to exist. There are powerful tools that can help investors minimize their exposure to risk, but the fact of the matter is, when all is said and done, the most successful traders almost always realize success because they have keen, seemingly intangible insights that allude most other investors.

Some call it gut instinct, others consider the practice of conjuring up and making (accurate) market predictions a form of mysticism. Demystifying the rhetoric is surprisingly simple once it is understood that both groups have one very important thing in common: both are voracious consumers of information.

Fundamental Analysis vs. Technical Analysis: Long Term vs. Short Term Investment Strategies

There are two prevalent financial theories professional investors use to analyze and predict future price movements within the precious metals markets: fundamental analysis, and technical analysis.

Fundamental analysis is a favorite among those who employ a long-term approach to investing and involves using key economic data to determine future trading decisions. Research that includes studying inflation, interest rates, currency valuations, energy prices, world politics, bullion supply and demand and more guides the fundamental analyst's investment strategy.

Technical analysis is popular with short-term investors and involves studying prices and charts to guide strategy. This theory assumes the underlying fundamentals that affect value are built-in to a given commodity's current price. Technical analysts believe market psychology determines prices; they study price patterns, moving averages, and market trends.

While both theories have strong advocates, most professional investors recommend using an analytical approach that combines both methods. Failure to take both theories into consideration prior to executing a trade can, depending on the size of investment, lead to significant trading errors.

For example, fundamental analysts that ignore (technical) trends may find themselves on the wrong side of a trade when their research suggests prices will move in one direction while historical trend data suggests a strong move in the opposite direction is imminent. Likewise, technical analysts may encounter timing errors if they discount the validity of key market news or other economic data prior to executing a trade.

A closer look at fundamental analysis theory follows the proceeding charts. A document that covers the core elements of technical analysis also appears further down this page. Go to technical document.

Studying Line Charts, Candlestick Charts and Bar Charts, Making Sense Of Data

Line charts track commodity prices on an OHLC (Open, High, Low, Close) basis.

As is evident by the information that appears throughout this site, line charts are fully customizable and can track prices across a wide range of time lines. For instance, the three line charts on the Home page show 30 minute intraday prices for gold, silver and platinum. The About page shows prices over the most recent hour. The News page offers a four hour price perspective.

Investors use line charts to determine overall price trends. To determine trends, they take one data point (most often the close) and connect the ensuing points. While line charts eliminate the bluster found in candlestick and bar charts, it can be risky to rely on these charts alone when picking specific market entry and exit points.

Due to their straight forward construction, line charts can also help investors detect price correlations that exist within individual precious metal markets. For instance, a quick examination of the preceding block of line charts shows that both gold and silver tend to trade, despite their dramatic price differences, along similar trend lines. There is also an observable correlation between platinum and palladium prices.

While the trends may seem arbitrary, it is important to understand why certain metals prices rise and fall together. In the case of gold and silver, investors generally consider both commidities stable monetary assets, but investors are also aware of volatile disparities that exist between the two. Since the beginning of the last century, one ounce of gold has roughly been equal to 15-16 ounces of silver. Today, silver bullion trades at a ratio that is ~65 times the current gold bullion spot price.

Could silver outperform gold in the near future? Many professionals think it is entirely possible, especially considering the fact that silver's current price is well below its historic highs. Line charts can be very useful in detecting potential breakouts. More information on how to use charts to track trends is available in the technical analysis document below.

Candlestick charts use vertical bodies (in the shape of candlesticks) to demonstrate price movements. The green/red part of the candlestick is the "body." The thin line that extends above and below the body is the "shadow" (or wick). The wick illustrates the highest and lowest price of a commodity during a specific time period. The body shows the opening and closing trades. If the commodity closes higher than its opening price, the body is green, with the opening price at the bottom of the body and the closing price at the top. If the security closes lower than its opening price, the body is red, with the opening price at the top and the closing price at the bottom.

Candlesticks are information rich charts that help investors zero in on and identify specific market entry and exit points. For example, when the bar is green and high relative to other time periods, it means buyers are bullish and more likely to enter a specific market. If bars are red, the opposite is true. Candlestick charts come in a variety of configurations from simple, like the ones below, to complex. The technical analysis document offers several complex examples.

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Bar charts, like line and candlestick charts, track a given commodities (OHLC) price a over specific time period. The open tracks the commodity's first price. The high tracks the commodities highest price. The low tracks the lowest price in the bar. The close tracks the commodity's final closing price.

Bar charts consist of an opening foot, a vertical line and a closing foot. They can be configured to show prices as they occur over one minute increments, one hour increments, four hour increments, one week, three months, five years, etc.

All trading information is built-in to each individual bar and directly corresponds to a given commodity's OHLC. Refer to the technical analysis document for more details.

Once line chart functionality is understood, once candlestick and bar charts make sense, visit the same sites that host these charts and start building your own. It is surprisingly simple and takes just a few minutes.

Fundamental Analysis: Understanding The Link Between Gold & The U.S. Dollar

At its core, gold is essentially a currency. For many years, gold's primary role as an investment vehicle has been to act as a stable, secure store of value, and a hedge against inflation. When investors believe the value of the U.S. dollar and other investments are showing signs of pending inflationary pressure, a phenomenon known as "flight-to-quality" often takes place.

Flight-to-quality occurs when investors take money out of their cash (or other) accounts and place it in markets which traditionally remain stable in the face of uncertain economic times. Gold is one of if not the most popular flight-to-quality markets. Because gold and currency interact in this way, they share what is commonly known as an "inverse relationship." When the price of gold goes up, the value of the dollar goes down. The same holds true when the price/value equation moves in the opposite direction.

While this inverse relationship has been proven valid over the course of many years, recent market activity has shown the inverse relationship is not necessarily a steadfast rule. As recently as early April 2010, both the price of gold and the value of the U.S. dollar rose simultaneously.

How Inflation Affects The Price Of Gold And The Value Of The Dollar

Bonds determine interest rates, interest rates determine inflation, inflation determines the price of gold, and gold determines the value of the dollar.

Simply put, inflation occurs when an economy experiences an unsustainable rise in the cost of goods and services. During inflationary times, the value of the dollar generally declines, and the price of gold rises.

Inflation can occur for many reasons. Sometimes inflation rises as a result of a rapid increase in an economy's money supply. Other times, a rise in commodities prices can lead to inflation. Because this section focuses on how inflation affects the price of gold, the following discussion will primarily cover inflation and its negative affects on the U.S. bond market.

In a stable economy, a bond's primary function from a retail perspective is to provide a safe haven for risk averse investors. The rate of return on a bond is usually lower than other investment options, but the risk of losing money on bonds is also (relatively) low.

The bond investor's primary foe is inflation. When inflation rises, bond investment returns decline. Inflation also often leads to higher interest rates which in turn weakens the value of the dollar.

Conversely, there are instances where commodities including gold actually benefit from inflation. This happens because commodities generally reflect future prices, tend to surge upward if inflation appears likely.

One reason the market may lose confidence in bonds and trigger both inflation and higher interest rates is because the market believes certain entities who take on debt by issuing bonds may have difficulty repaying the debt. If confidence in a large bond issuer slips or entities begin defaulting on their debt obligations, interest rates may increase, which may make borrowing money or issuing additional bonds more expensive.

The raising of interest rates also has the effect of making large gold purchases that occur between central banks and other large investment groups more expensive to finance. As it becomes more expensive to own, gold demand may drop because unlike other investments, gold does not pay interest or dividends. In the face of rising prices, flight away from gold and into interest bearing equity markets may occur.

Remarkably, since the beginning of the most recent financial crisis, U.S. inflation has mostly been kept in check, and interest rates have consistently been kept very low.

Even as countries throughout Europe either have been experiencing or are on the verge of entering financially challenging times, the U.S. economy continues to remain resilient. The question many economists have been asking is "how much longer can the U.S. extend (credit) and pretend" that current prices across all asset classes actually reflect reality? Many suspect the answer may reveal itself sooner than contrarians think.

Both interest rates and inflation have been kept low through the application of controversial monetary policies, such as one currently being run by the Federal Reserve known as "quantitative easing." QE on a regular basis injects untold billions of U.S. dollars into the economy in an attempt to keep, among other things, interest rates and inflation at manageable levels.

Quantitative easing (QE) has in the past been made visibly available to entities such as public works projects, jobs programs, and residential real estate markets. Annecdotal evidence suggests less visible QE activity may be responsible for helping prop up Wall Street firms and their clients as well as banks and other financial institutions.

Whether or not QE technically includes money the government has been using to purchase its own debt is unclear, but this much is certain: pumping untold billions if not trillions of dollars into the economy has dramatically increased the U.S. money supply. And as history has proven time-and-time again, any dramatic increase in the money supply almost always leads to inflation, which brings us back to gold.

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The government taking such enormous risks, flooding the U.S. economy with inordinate amounts of cash, it is their belief this will eventually help stabilize the economy. Compounding this problem is the fact that governments throughout the world are also flooding their economies with inordinate amounts of cash.

It is entirely possible that U.S. government officials responsible for implementing and monitoring the distribution of various QE programs are banking (betting) on the restorative effect of a few key economic factors that are currently working in their favor.

First, the U.S. dollar is still the world's reserve currency. The world measures the price of oil, gold and other key commodities against the value of the U.S. dollar. Due to economic instability overseas, many foreign investors still regularly invest in and hold U.S. dollars versus their own currencies because most of their currencies (relative to the U.S. dollar) are less stable. While the influx of foreign capital into the U.S. currency market necessarily helps stabilize the U.S. dollar, there is evidence that foreign investors have recently begun limiting such activities.

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The U.S. government also appears to banking on the fact that the world is seemingly incapable of satisfying its desire to own gold. How this reality works in the government's favor is not as easy to understand and requires a fair amount of speculation. Attempts at explaining this rationale appear later in this section.

The preceding observations should help readers better understand why gold and the U.S. dollar's inverse relationship now tend to share common trajectories. In short, the U.S. dollar and precious metals are two in an ever shrinking pool of investments that currently show signs of maintaining near term stability.

It's no secret that quantitative easing is currently taking place. More than a few European countries are facing financial crises. The U.S. government is financing its operations through the monthly acquisition of its own Treasury Bills. The U.S. economy is still mostly unstable. Foreign goverments and their agents are increasingly reluctant to purchase U.S. debt and/or participate in motionless equity markets.

If the word on the Street is true, many (inactive) traders are curious to know why the equity markets continue to climb despite lackluster participation and uncharacteristically low trading volumes. Many suspect QE is at least partly to blame. While many traders remain on the sidelines, it's likely more than a few reap some form of solace from the fact that precious metals prices continue to soar, if for no other reason, because soaring precious metal prices actually makes sense.

Extrapolating, taking key economic and market information and drawing clear and concise inferences from it, is what fundamental analysis is all about.

Understanding The Relationship Between Fluctuating Gold Prices And Physical Gold Inventories

Applying basic economic supply and demand principles to the precious metals markets can help astute investors better understand how precious metal prices are dependent upon and help determine precious metals inventories.

Experts estimate the "paper" gold market controls 90 percent of the world's physical gold trade. Analysts also estimate a gross volume of 2,100 metric tons of gold trades hands on a daily basis. Assuming a spot price of $1,150 per ounce means $77 billion dollars worth of gold trades every single day.

Interesting note; collectively, all the mining companies in the world produce 2,200 metric tons of gold per year. This figure represents the world's yearly demand for gold. Historians estimate 161,000 tons of gold has been taken from the earth since records were first kept while only 15,000 metric tons of London Good Delivery bars exist in the world.

While many may assume transactions between gold buyers and sellers necessarily involves the exchange of physical gold, this is usually not the case.

Most of the time when gold is bought or sold, the transactions take place in the gold futures markets in New York and London. The only thing that trades between gold futures buyers and sellers is paper. How the trading of gold futures affects both physical gold prices and physical gold inventories may come as a surprise to those who are unfamiliar with how futures markets operate.

Paper gold exists in three forms: as an ETF (exchange traded fund), as a futures contract, and as gold stocks. ETFs, futures contracts and gold stocks trade separately on the Commodities Exchange (COMEX) and other exchanges around the world. For a complete explanation of ETF funds, click here and scroll down. For more information on futures contracts, click here. To learn about gold stocks, click here.

The most popular gold ETF is GLD.

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Gold ETFs are a relatively new form of paper gold and function similarly to mutual funds. Gold futures contracts have been around for many years. Gold futures are contracts that guarantee the future delivery of gold at any agreed upon price. Investors buy gold stocks when they wish to invest in companies that explore or produce physical gold.

One of the most popular gold stocks is GOLD.

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To understand how gold prices and physical inventories are linked, it is first important to understand how gold makes its way to the market.

Every prosperous country in the world has its own central bank. The central bank in the U.S. is the Federal Reserve Bank of New York. Europe has the European Central Bank (ECB). Countries throughout Europe also have individual central banks. (A complete list of all central banks is available here.)

All of the world's central banks are committee members of and communicate through the Bank Of International Settlements (BIS). The BIS is a policy-driven, international organization whose primary function is to set global banking standards.

Central banks have "agents" which are also known as "bullion banks." Bullion banks are typically large investment firms that deal directly in the gold markets. Bullion banks are buyers, sellers, lenders, and borrowers of gold. Through their agents, central banks make their gold inventories available to the future's trading pits, physical gold and stock markets, and to corresponding banks overseas. (A complete list of bullion banks is available here.

Because central banks essentially control the world's gold supply, they have the unique ability to excersize tremendous oversight within specific gold markets. Through their powers, they can control gold price, gold supply, and dictate the terms of physical gold delivery.

Through their agents, central banks also have the ability to influence interest rates and inflation.

Better than annecdotal evidence seems to suggest that it's possible the central bank regularly manipulates gold prices for its own purposes. For example, presenter for the 2005 annual BIS conference William White, then head of BIS Monetary Policy, said there are five "intermediate objectives of central bank cooperation," the fifth being “the provision of international credits and joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful.”

Former Federal Reserve Chairman Alan Greenspan made similarly curious statements in 1998 while testifying before the Commodity Futures Trading Commission. Greenspan was speaking to provide evidence as to why the CFTC should not involve itself with regulating the over-the-counter derivatives markets.

In his speech, Greenspan said “there is no reason to believe either equity swaps or credit derivatives can influence the price of the underlying assets any more than conventional securities trading does.” Greenspan went on to wave off the need for CFTC regulation of gold derivatives and said “central banks stand ready to lease gold in increasing quantities should the price rise.” The real purpose of gold leasing, according to the former Federal Reserve Chairman, is to drive gold prices lower.

Another interesting example of gold price manipulation was made during the September 1999 signing of the Washington Agreement. A machination of ECB members, with the full support of the U.S. central bank, the Washington Agreement laid the ground work for central banks around the world to begin fixing gold prices by setting a limit as to how much gold central bank members could collectively sell in a given year.

While such a move might appear to be a protective measure, others view the cental banks' motives in an entirely different light. Interesting enough, as the central banks began limiting how much physical gold they would sell in a year, many suspect the same group began manipulating derivatives markets which ultimately may have had the effect of keeping gold prices artificially low.

Some suspect the central banks' gold price manipulation has very little to do with the commodity itself but instead is meant to work as a mechanism that keeps inflation low and the dollar stable.

In such an arrangement, bullion banks cause gold prices to fall by shorting (selling) enormous amounts of gold through the futures market which in turn affects the larger economy by creating, among other things, artificially low inflation rates. The bullion banks enter large short positions knowing these positions will drive the price of gold down. With gold at lower prices, the bullion banks cover their positions by buying gold contracts back at lower prices. The procedes are then sunk in the U.S. bond markets where they generate additional profits.

Similar arrangements between central banks and their agents include even more complex activities, such as the practice of engaging in "gold swaps." The following IMF document describes how gold swaps work.

Assuming these suppositions are more akin to fact than fiction, it isn't particularly difficult to see how such arrangements would be agreeable to all participants. The bullion banks would be happy to receive endless streams of free money. The Treasury Department, equally happy to realize a boost in bond prices while keeping interest rates low.

Whether or not such high trading volume has had an effect on central banks' gold reserves is impossible to verify. Neither the world's central banks nor their agents make the exact amount of gold currently held in reserve known to the public.

One of the U.S. central bank's main gold storage facilities, Fort Knox, has not seen an audit since President Eisenhower was in office. The U.S. government claims to hold 8,000 tons of gold in reserve. Other estimates suggest the total amount of gold held by all central banks is around 30,000 tons.

Pushing the preceding scenarios aside, it is not unreasonable to assume that shorting of gold by bullion banks, on a massive scale, occurs every single trading day. In fact, on an average day, the futures market trades about the same amount of gold the entire world produces in a single year. Further complicating matters is the fact that gold futures currently trade at a 100-to-1 reserve ratio, which means for every 100 futures contracts sold, only one ounce of gold is held in reserve.

Some proponents claim shorting is essential because it provides market liquidity. Others claim there is no cause for concern because trading on a fractional reserve basis has been the norm for many years. The problem with these arguments is that they both keep gold from rising to a price that more accurately reflects its real market value, a value which many believe is well above its current price.

A look back to 1980 shows gold was trading at $850 per ounce. Adjusting that price to include inflation, gold should currently be trading at over $2,200 an ounce. But it's not. Many say this fact is proof positive that gold and inflation do not share an inextricable link. The same people usually have a difficult time explaining the obvious discrepency.

Is it possible central banks have been controlling gold prices as far back as 1980s? Without knowing for sure, it seems foolish to discount the possibility. If the central banks and their agents are in fact engaging in price manipulation, is this a practice that can continue indefinitely? This seems less likely.

As an indirect beneficiary of the world's central banking system, the International Monetary Fund (IMF) controls a sizable gold reserve. The IMF's gold reserves are made up of deposits that are sent to them from the world's central banks. In early 2010, Eric Sprott, CEO and Chief Investment Officer of Sprott Asset Management, expressed interest in buying the remaining 191.3 tons of IMF gold. The IMF quickly let Sprott know that they were physically unable to sell any gold.

Whether the IMF's refusal came about because it did not actually have that much gold available for sale is unclear. Perhaps the IMF simply thought that it was the wrong time to sell. Either way, their untold motives for denying Sprott's bid add at least some credence to the growing concern that some of the world's gold reserves may be nowhere near as large as their owners' suggest.