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The Story Behind Gold's Mini-Flash Crash

Investopedia logoInvestopedia 03-08-2015 Sean Bryant
The gold market was rocked last week by a sudden drop in prices. There are a number of factors that can lead to a flash crash in any market. © shutterstock The gold market was rocked last week by a sudden drop in prices. There are a number of factors that can lead to a flash crash in any market.

Whenever something major happens the markets react. For instance, when 9/11 hit, the stock markets tumbled in reaction. When one giant company buys another, or refuses an offer from another, that company's stock prices will jump or drop. Sometimes these dips are logical, other times they are simply knee-jerk reactions from over-zealous traders.

That is, to an extent, what happened last week when gold prices took a sudden tumble. However, there are things to watch out for whenever there is a flash crash in any market.

The Cause of Gold’s Mini-Flash Crash

On Monday July 20, just as the Chinese markets were opening for trading (about 9:30 pm EST on Sunday July 19 in the U.S.), someone sold a ton of gold. Actually, they sold about 5 tonnes of gold in a matter of minutes. For some commodities, that would not be a big deal. For gold, which generally trades 25 tonnes per day on the Chinese market, that was a huge deal.

The sudden influx of gold caused the price to drop to $1,088 per ounce: a five-year low.

The Underlying Cause of the Gold Sell-Off

There are a number of theories as to why someone (in this sense it could be a corporation, or a group, not likely an individual person) would suddenly dump that much gold. (For more, see: How Safe Are Gold and Silver Investments?)

Low Liquidity: Commodities go through cycles. Sometimes buying and selling is very easy to do. This drives the price down as a highly liquid investment is easy to move. However, there are periods where commodities are not moving quickly. These periods of low liquidity make the prices a bit higher. An investor may have been capitalizing on the higher prices and dumping gold into the market to harvest gains.

Margin Calls: A margin call is stock market lingo for “pay your debts.” Essentially what happens is that someone has borrowed money to buy gold. The price of gold has dropped too far, and now they owe a lot more for the gold than it is actually worth. Instead of continuing to let the value decline, the investment company will “call” the debt and automatically sell the gold to cut—at least some of—their losses. (For more, see: Industries Prone to Bubbles and Why.)

Now there are some other issues to this selling of gold that likely had a play in this massive sell-off.

Chinese Gold Market

On Friday July 17 there were two major gold events that took place.

At the end of the day gold closed at its lowest level since 2010. Back in 2011, gold was valued at about $1,900 per ounce. By July 17, that had dropped to about $1,130. By the end of the day on Monday July 20, gold dipped below $1,100 because of the sell-off. You can see the trend in this 30 day Kitco graph.

Along with this slump in gold prices, Friday July 17 had more news in store. On this day China announced how much gold they had in their reserves. Since 2009 those reserves grew 57% and China now holds 53.32 million troy ounces of gold.

But what does that all mean? The first event, the fact that gold has declined in value, means that it likely is not someone harvesting gains on their investment. The second, the announcement, could indicate that the Chinese government is selling some of their gold. Or that someone is wary of the government holding that much gold. (For more, see: How to Spot a Sell-Off.)

The Bottom Line

As an investor, gold’s declining value means that you are in a position to buy gold cheaper. However, you must be wary; if the underlying issue was a margin call, it could mean some other serious financial strains are going on. That could mean that the value of gold will decline even further.

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