Following Gold

Gold is the ultimate global currency. At one time US Dollar used to be pegged to gold. But with the collapse of the Bretton Woods System, US Dollar was unpegged from gold.

Now US Dollar is only backed by the full faith and credit of the US Government. In times of financial crisis like the present when the global economy is in recession, many investors try to take refuge in gold as the ultimate safe haven.

The Australian Dollar (AUD) is known for its strong correlation with gold prices among the different currencies in the world. This correlation is due to fact that Australia has gold deposits and exports gold. On the other hand, USD has an inverse relationship with gold prices. Gold prices rise, USD falls in value. This causes the currency pair AUD/USD to appreciate in value when gold prices rise.

The opposite is also true. As the US Dollar gains value, gold usually loses value. So when gold prices are rising, we can execute long trades on AUD/USD. Likewise, when gold falls in value, we can sell short AUD/USD. This relationship provides us with a method to take advantage of the fundamental factors in forex markets. It may be due to the fact that gold is considered to be the ultimate safe haven by investors in times of financial crisis.

How do you follow gold in currency trading? We now know that AUD/USD pair reacts strongly to gold prices. So we will trade AUD/USD based on following gold. Entering a trade to follow gold is a three step process. Use RSI (Relative Strength Index) as the technical indicator to trigger the trade. If you have read the previous article on following oil in currency trading, we had used the CCI (Commodity Channel Index) to trade USD/CAD pair.

When both gold and oil are commodities, why dont we use CCI for gold as well? Why is that we are using RSI now? CCI gives a quicker signal. This is good for relatively less volatile pairs like USD/CAD. Whereas RSI gives slower signals, this is ideal for more volatile pairs like AUD/USD. It all depends on how quickly the two indicators react to volatility.

You should use a moving average to confirm if gold is in an uptrend or a downtrend. You will use the seven periods RSI on AUD/USD chart. Watch the RSI chart when it enters one of its reversal zones, then move back out of the reversal zone in the same direction as the gold is trending.

You should enter a long trade on AUD/USD if the gold prices are rising and the RSI is crossing back above the 30 line. On the other hand, you should enter a short trade on AUD/USD pair if the gold prices are declining and the RSI is crossing below the 70 line.

Set a limit order of 200 pips and a stop loss order of 50 pips for the trade. This gives a risk to reward ratio of 50/200=1/4. This risk to reward ratio is good. The chances are you are going to make 200 pips that means $2000 profit if the trade goes as you had anticipated. And if the trade does not go in your favor, 50 pips stop loss means a $500 loss. It is not uncommon to have a trade go against you only to find yourself right back in trade that goes your way after sometime.