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What Happens When Gold Diverges From the USD? |
by John Jagerson
Gold has a strong inverse correlation with the USD. When the USD is rising in value, gold is typically falling in price because it is priced in dollars and it takes fewer stronger dollars to by an ounce. When the dollar is losing value or inflating gold will rise in value because it takes more weaker dollars to buy an ounce. This rule is true 80% of the time. However, periodically these "twins" will diverge and this is what presents opportunity to traders.
In the video I will compare a gold ETF (GLD) with the EUR/USD forex pair as a proxy for the value of the US Dollar. Because the US Dollar is the quote currency in that forex pair these two instruments should have a very positive correlation. Currently, this positive correlation has broken down and the two markets are diverging. This has happened in the past and will happen again in the future. For another take on the relationship that gold prices have to the forex, click here.
What traders look for when this divergence occurs is a reversion to the normal correlated relationship. The divergences are typically short term and the subsequent correction can be quite dramatic. In the current case, gold is rising in value at the same time that the USD is also rising in value driving the EUR/USD down. The question is not whether they will come back into line with each other but whether that correction will be a decline in gold prices or the value of the USD.
Strategically this opportunity could be addressed in the same way you may approach a pairs stock trade. Shorting the instrument that is rising (GLD) and taking a long position on the falling instrument (EUR/USD) could provide a nice opportunity to profit. What you are trying to accomplish with this trade is to capture the the profits available when these two assets merge back together. To learn more about stock pairs trading, click here.
Alternatively this signal can be used as an indicator that volatility is coming for forex or gold traders already in the market. In the video I will cover two recent examples of divergences that corrected very quickly and could have taken traders by surprise. Traders can take action to remove some of their market exposure in light of the pending volatility by covering long gold positions or short EUR/USD.
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