Humans have long been fascinated with gold for its colour and lustre and initially used it to create jewellery and religious artifacts. Due to its physical attributes – it doesn’t corrode or tarnish – it soon turned into a store of value and a symbol of wealth.
It was the ancient Egyptians that introduced gold coins for international trade and with that, gold acquired another role as money. For part of the 19th and 20th centuries it was used to underpin the value of most nations’ currencies, known as the gold standard. Under that monetary system, one unit of currency equalled a fixed amount of gold, and it was freely convertible into the yellow metal.
Nowadays, no country fixes its currency to gold, but this doesn’t diminish the value attributed to the precious metal. To this day, central banks and governments hold huge reserves of physical gold in their vaults. This adds to the significant role the yellow metal plays in modern-day capital markets as a financial instrument.
Gold is one of the most popular financial instruments to trade, which involves speculation on gold prices for financial gain. Gold trading occurs in many shapes and forms, whether it’s trading physical gold coins and bars or assets that are just linked to the precious metal or its price. These are known as derivative instruments and include futures contracts, forwards, options, or swaps.
One of the most popular forms of gold trading is via contracts for difference (CFDs), CFDs are derivatives that allow traders to speculate on price movements on precious metal markets without taking ownership of physical gold bars or coins.
What is CFD trading and how to trade gold CFDs
The form of gold trading ThinkMarkets offers is through CFDs that track the spot price on global financial markets.
Gold CFDs are derivative instruments created by a broker. It is a contract between the trader and broker, entered to make financial gain. As gold is denominated in US dollars, the instrument to trade is quoted as a pair – XAU/USD.
CFDs are leveraged products that allow traders to borrow money from their broker to complete transactions that are larger than their initial deposit. It’s important to note that trading with leverage carries the risk of amplifying losses if the price moves against your position, as much as it can multiply gains, when the price moves in the same direction you expected.
Traders should develop a trading strategy carefully and make sure they fully understand the use of leverage before they start trading. They should also be mindful to apply risk management techniques to limit potential losses.
The benefits of trading gold CFDs
- When trading CFDs, traders are only entering a contract aimed at exchanging the price difference between the opening position and the closing position with a broker. This means, a trader does not have to store any physical gold in order to trade it, saving the cost of storage.
- One of the greatest advantages of trading CFDs is that it doesn’t matter if the price of gold is rising or falling. Traders can try to predict which direction the price will move next. If they think the price of gold will go up, they open a buy a position (also called going long), if they think the price will drop, they enter a sell a position (also known as going short).
- The third major advantage of trading CFDs is that it involves the use of leverage, which multiplies the trader’s purchasing power as only a small deposit will suffice to carry out a sizeable transaction. It needs to be highlighted that as much as leverage amplifies gains, it also multiplies any loss.
How leverage works in gold trading
Financial leverage is a strategy of using debt (borrowed money) to increase the potential return on a financial transaction.
With the help of leverage, trades can be carried out by depositing only a small amount. For example, to trade a gold position worth 1,000 US dollars, you only need to put down 10 dollars. This deposit is called the margin requirement.
Examples of trading gold on leverage
When the leverage for gold trading with a specific broker is 20:1, that means that a trader opening a gold trading account with that broker can open a trade 20 times their deposit. As an example, they can place a trade of USD 2,000 for USD 100. The margin requirement for this trade is 5%.
For a trade of any size, the trader will need to deposit 5% of the value of the trade, with the balance provided by the CFD broker. For example, for a sizeable, USD 100,000 trade, you need to put down a deposit (margin) of USD 5,000.
Let's see how it works through some examples of gold trades.
A winning example of a gold trade
Let’s see a profitable trading scenario without leverage:
You expect the price of gold to go up from its current level of USD 1,000. You set your position size at USD 1,000. For a trade without leverage, you need to put down the full USD 1,000. You close the trade when the gold price rises to USD 1,100. Your profit is USD 100.
The same trade scenario with leverage:
The gold price is USD 1,000. Your broker offers you leverage of 100:1 on gold. Your margin requirement, therefore, is 1%, or USD 10. You open a position worth USD 1,000. The price rises to USD 1,100 and you close out the trade. Your profit is USD 100. However, as opposed to the scenario without leverage, you only had to deposit USD 10 rather than USD 1,000 to make the gain.
This example also served to illustrate how leverage amplifies any gain, however, traders must bear in mind that it will enhance any losses, too, if the market moves against them and their prediction doesn’t prove correct. Leveraged trading with CFDs may mean that traders can lose more money than they initially deposited.
A loss-making example of a gold trade
Let’s examine an unprofitable scenario without leverage:
You expect the price of gold to go up from its current level of USD 1,000. For a trade without leverage, you need to put down the full USD 1,000. However, the gold price goes down to USD 900 when you close your trade. Your loss is USD 100, or 1/10th of your deposit.
The same unprofitable scenario with leverage:
The gold price is USD 1,000. Your broker offers you leverage of 100:1 on gold. Your margin requirement, therefore, is 1%, or USD 10. The gold price falls to USD 900 when you close out the trade. Your loss is USD 100. This is 10 times more than your initial deposit.
As you used leverage and only deposited USD 10, the money you now need to pay is an additional USD 90 on top of your USD 10 deposit.
This example shows how the use of leverage can multiply your losses. By using trading strategies that incorporate risk management tools, such as stop-loss and take-profit orders, traders can minimise their risk when trading CFDs with leverage.
ThinkMarkets gives you access to precious metals markets. Trade gold CFDs on our award-winning platform, ThinkTrader. Express your view on where the price of this precious metal is headed. Trade in any direction without owning any physical gold. Go long or go short with competitive spreads and fast execution. Create an account today.
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