Commodities differ from stocks or bonds in the fact that, usually they have significant importance for some industry. For example, silver is used in the production of electrical conductors and oil is used as fuel for various kinds of machines. The main difference from a financial point of view is that, other than bonds and stocks, commodities do not give you cash flows in the like of dividends, coupons or the principal. The only way in which commodities generate returns (excluding industrial applications) is when their price changes in the direction you bet on.
The main idea behind the gold-oil relation is the one which suggests that prices of crude oil partly account for inflation. Increases in the price of oil result in increased prices of gasoline which is derived from oil. If gasoline is more expensive, than it’s more costly to transport goods and their prices go up. The final result is an increased price level – in other words, inflation. The second part of the causal link is the fact that precious metals tend to appreciate with inflation rising (in the current – fiat – monetary environment). So, an increase in the price of crude oil can, eventually, translate into higher precious metals prices.
TRADING INDICATORS
Moving Averages
The simplest indicator one can use is the moving average. This can, for example, be the 9 and 20 day moving averages (MA). The analyst will study their cross-overs and the relative position of the price with respect to the moving averages. Prices movements on a chart can be shown in different formats such as bars, candles or lines. The cross-over between two moving averages may signal a change in trend. When the fast MA (9 day) crosses the slow MA (20 day) from below to above, it will signify a bullish trend. If it crosses from above to below, it will signify a bearish trend. Moving averages may in some situations be used as support or resistance levels for a given trade.
MACD
Another commonly used indicator is the MACD, which is an abbreviation for Moving Average Convergence Divergence. The MACD is a trend-following momentum indicator that measures the difference between two Exponential Moving Averages (EMA).
Simply put, when the MACD is rising it indicates that the 12 day EMA is trading above the 26 day EMA. This implies positive momentum. If this is above the ‘trigger line’ (the 9 day EMA) then the stock is considered bullish. If both lines are falling, the stock is under selling pressure.
The simplest interpretation of a bullish (bearish) moving average crossover occurs when MACD moves above (falls below) its 9-day EMA or ‘trigger line’. If a market is trending down but the ‘trigger line’ rises above the MACD, this implies that downward momentum is decreasing and there is a good chance that a reversal is imminent.
The RSI
The Relative Strength Index (RSI) is used to identify when a market is overbought or oversold. It is computed by analysing all the bullish ranges against all the bearish ranges during a particular period of time (usually 14 days). By adding all the bullish trades (when prices went up) and dividing it by the summation of the bearish days (when prices went down) we then turn it into an index from 0 to 100. A general rule is that when the RSI crosses the 30 line from below, it signifies a bullish signal and when it crosses the 70 line from above, it signifies a bearish signal.
Stochastic
This indicator is based on the observation that, as price is moving higher the closing price tends to be closer to the upper end of the day’s price range. And when prices are falling, the closing price tends to gravitate to the lower end of the day’s range.
The Stochastic is plotted as two lines called %K, a fast line and %D, a slow line. The most common time period for %K is 14 days, but like the RSI it is best to experiment to find what time period works best for a particular market. What %K measures on a scale of 0 to 100, is where today’s close is relative to the total 14 day range. The %D line is a moving average of %K.
Readings above 80 are considered overbought and readings below 20 are considered oversold.
Bollinger Bands
The basis of these relate to the theory that a market’s probable movements (up or down) can be traced to two standard deviations. This means that 90% of all price movements will be confined within a band around the mean. The latter is usually computed from a 20-day moving average and the bands are on either side of the mean. The bands will contract or expand as the price of the commodity oscillates within the bands. As the daily ranges approach the band on either side and exceed the band value, it may signify that a reversal is imminent.
Interpretations
With regard to the MACD, the RSI and the Stochastic, the above ‘rules’ are a very simplistic interpretation and will lead to many false signals. A better interpretation is to:
1. identify support and resistance levels;
2. define the ‘signal line’ and look for breaks above or below it; and
3. wait for divergences to develop from overbought or oversold levels.