01 June 2008

Investment timeframes - Part II

Short Term

Following on from last week, why do I say that the nature of the gold market itself makes profitable day trading difficult? It is all about information, or lack thereof. Apart from pockets of relative transparency like COMEX or ETFs, the vast majority of the market is opaque. The “retail” or “average Joe” trader simply does not have access to the same amount of information about the status of the market and its flows that a “wholesale” trader does (and even they can’t see the entire market). Without understanding what is really driving short term changes in the price, I doubt it is possible even for the most astute and disciplined trader to make consistent profits.

Let me contrast it to stock markets. There are a few key features that help the day trader. Firstly, you know exactly how many shares have been issued and if there are different classes, how many of each and what the differences/rights each has. Secondly, all trading is done through (usually) one regulated market. Thirdly, you can see daily trading volumes. Fourth, at any point in time you can see the depth of the market – how many shares are being offered to buy or sell at each price level. This mass of data, combined with analysis of price charts, gives the trader room to apply skill and a bit of gut instinct to the task of making a profit.

How does the gold market stack up on these features? Firstly, no one knows for sure at any point in time how much gold there is out there to be traded, nor in what form or in what locations. The wholesale market may have a bit of an idea, but no such information is published to retail traders on a daily basis. Even if one did know the size of the gold out there at that point in time, due to its refinability, scrap gold can flow back into the market quickly (a factor if you are planning on holding a position for a few weeks), so the total “shares on issue” in not fixed and changes in response to the price.

On the third and fourth points, there is no published information on daily trading volumes or market depth; indeed, no volume data is published at all. I’m talking here about the whole market. Sure, some gold is traded on regulated markets but that information is only part of the picture and certainly little of it is live. If you only have part of the story, you don’t have the story at all in my opinion.

Network Nature of the Market

The key killer for me is the second point – gold is simply not a publicly, regulated traded thing. And COMEX and ETFs and the like don’t go anyway towards solving that because they are not closed systems. It is easy to run a position in those markets that are offset or hedged with an opposite position in the spot/forward market. Detailing how that is done is for another blog. The gold market operates much like the internet – it is a network of wholesale dealers, independently trading with each other, and it is the sum of those individual trades that makes up the “spot market”.

It was always amusing to me when clients would ring up to buy and we would quote a price and then, naturally, they would say “Well, where can I get what the spot price is?” so they could work out if our price was “fair”. The answer was, “It doesn’t exist. You could spend a few thousand getting a live Reuters data feed, but even that is just indicative.” Being used to the comforts of a stock market, many didn’t like that answer and thought we were pulling a shifty on them. In the end, all we could say was that they had to do what we did, which was ring around to see who was offering the best price at that time. It made some uncomfortable, but as I pointed out in my first blog, this is the “pointy end” of investing, it’s real trading, it is about bargaining, haggling, being in the know.

The funny thing is that this network nature also gives the market strength. Transparency is nice, but not at the expense of robustness. Just like the internet, where if a part goes down then data can be rerouted, if London was nuked for example, then trading in gold could still continue. Sure, liquidity would be reduced, but as deals in the end are done over the phone, it is just a case of dealing with other counterparties in other countries. Because it is not locked in to one “exchange”, gold can be resilient in the face of a failure in part of the network. And this is how the medium and long term investors want gold to trade if it is to be the asset of last resort. The market needs that flexibility to if it is to continue trading.

But the network nature of the market and the corresponding lack of transparency is a problem for the day trader. To understand what the retail trader is up against, it may be better to explain what happens when they call up to buy some gold from a dealer. There are many small variations to how this can work; this is but one way, probably the simplest where a dealer just lays off a trade with someone else immediately instead of holding a position.

Spot Trading

Any trading desk needs an indicator of where the market is, and most use Reuters. However the price displayed on Reuters under code XAU is just an indicator. It is updated by the bullion desks of the big banks and is in effect, a bulletin board or forum where banks can publish their prices in the hope other dealers will call them up to do a trade. Sort of like an advertisement. Unlike a stock market, it is not a commitment to deal at those prices, but most times you can. However there are many times, especially when the market is moving quickly, when the dealers don’t have time to update their quotes on Reuters and so when you ring them up, they say “Sorry, Reuters off the market, my current price is $5 below the screen”.

As a result, when you call a dealer for a price, they themselves cannot really know exactly where the market is. They see $900 on the Reuters screen, but this is what they will be charged, so they have to add something on to it as they have to make a profit (you expect something for nothing, it costs to run a trading desk, to talk to you, to do the other side of the trade with the bank, to settle the funds, bank fees etc). The dealer also has to consider that by the time they get off the phone with you and then call another wholesale dealer the market may have moved, so they might need to add a buffer on top of their margin. Sometimes if your deal is big enough and the market volatile, they’ll get another trader on their desk to call a bank and get a firm price before they quote to you (and they’ll want an answer quick because the bank ain’t gonna want to sit on his quote for too long because he/she has got to trade it as well).

Dealers have a network of other dealers they trade with. Each dealer has a different bit of the gold market pie, they can see what is driving their deals (be they a refiner selling a miner’s gold, a bullion dealer selling coins and so on), but not necessarily what is driving other flows. They are in constant contact with each other, doing deals, talking and exchanging information on what they are seeing in the market, watching the Reuter’s price movements. They use all this information to set their prices and to ensure they don’t lose money. Over time they build up a gut instinct, a feel for market movements and where it might go that day.

If you call up the Perth Mint to trade, you are likely to speak to Deniece, the Mint's senior bullion dealer. She has what I would consider probably the best background training for a bullion dealer - croupier at Sun City. When the market is moving you can do any number of deals before you have time to enter them into the system to confirm your position and profit, so you have to be able to run them in your head, to know where all your 'gold chips' are on the 'table'. She has been there since 1994 and every working day she has been sitting in front of a computer screen watching the Reuter’s gold price tick up and tick down, talking to people like you wanting to buy or sell gold – that’s coming up to 4,000 days of trading. And you think you can day trade against dealers like her, with zero information about what’s going on in the market? Get real.

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