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. Most of the currencies in the world are free floating now. Many countries are also purchasing gold in the open markets as a hedge of their foreign reserves most of which are in US Dollar. In the present financial crisis with the global economy in recession, many investors are trying to take refuge in gold as the ultimate safe haven of their wealth from financial turmoil.
Among the different currencies, the Australian Dollar (AUD) is known for its strong correlation with gold prices. Most of this correlation is due to amount of gold that Australia produces and exports. On the other hand, US Dollar has an inverse relationship with gold prices. When gold prices rise, US Dollar falls in value. This causes the currency pair AUD/USD to appreciate in value.
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.
Entering a trade to follow gold is a three step process. We will use RSI (Relative Strength Index) as the technical indicator to trigger our trade. If you have read the previous article on following oil, we had used the CCI (Commodity Channel Index).
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 need to enter a long trade on AUD/USD if the gold prices are rising with the RSI crossing back above the 30 line. On the other hand, you need to enter a short trade on AUD/USD pair if the gold prices are declining with the RSI 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.