The Swinging Pendulum of the Gold Market: How to Trade the Middle

By: George Cocalis | Mon, Nov 17, 2008
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I recently observed the pendulum clock on my fireplace mantel and noticed the similarities between the recent price action in the gold market and the back and forth motion of the pendulum. Both have pivots, mid points, full and half swings, time and length. Pendulum swings in the markets are usually based on opinions. When talking about opinions, the famous author Arthur Schopenhauer stated it best: "Opinion is like a pendulum and obeys the same law. If it goes past the centre of gravity on one side, it must go a like distance on the other; and it is only after a certain time that it finds the true point at which it can remain at rest." The latter part of this statement is of interest since gold has seemingly found its comfort zone.

There are times when there are dramatic moves on the upside, such as the run up in gold in September registering an almost 200 point move. This extreme price action is usually met with a correction as witnessed in October's 257 point slide. This sets the stage for the next trade which is a trading range or sideways action. This is healthy price action that is normal following extreme pendulum moves such as we have seen. This corrective price action can be frustrating for gold bugs in the near term, but this can also be a time where gold bugs might use the lull to build equity until gold reaches that so far illusive $1,000.00 level. So, how do you trade in a sideways or range-bound market? In one word, OPTIONS.

Selling options differs substantially from buying options because short options are subject to daily price fluctuations and margin calls. However, selling options has also been likened to a melting ice cube, meaning that the actual time decay can be beneficial to an options seller. A short strangle, where a trader simultaneously sells puts and calls, can be used in a market that has no direction in a given time period.

For example, let's say that you think gold is in a trading range and will not have a powerful rally or a steep selloff in the next 10 days, with the November options expiring on the 20th of November. If you sell one contract of the $810.00 calls and at the same time sell one of the $680.00 puts, you would collect about $1,600 in premium (prices from November 6, 2008). If the gold market stays between $680.10 and $809.90 up to and including on expiration day, then the premium earned will be posted in your account. If the market looks like it might move below the low end of the range or above the high end of the range, the position can be rolled to the next delivery month. Such adjusting moves will incur additional commissions, but the moves also preserve the premium and avoid exercise or assignment of the options. I prefer to sell the strangles with less than 2 weeks left until expiration and establish the range using our technical numbers. There is the same risk with strangles as in any other strategy and such trading is not suitable for every investor, and I encourage further reading on this subject or that you contact a futures broker to explain the strategy in full detail. Investing in options can be a nice complement to your long positions if properly understood and applied.

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Chart courtesy of QST

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More to come......



George Cocalis

Author: George Cocalis

George J. Cocalis
800.971.2448 or 312.8963970

DISCLAIMER: Futures and options trading involves substantial risk of loss and is not suitable for every investor. The valuation of futures and options may fluctuate, and, as a result, clients may lose more than their original investment. The impact of seasonal and geopolitical events is already factored into market prices. Prices in the underlying cash or physical markets do not necessarily move in tandem with futures and options prices. In no event should the content of this correspondence be construed as an express or implied promise, guarantee or implication by or from Brewer Futures Group, LLC, Brewer Investment Group, LLC, or their subsidiaries and affiliates that you will profit or that losses can or will be limited in any manner whatsoever. Loss-limiting strategies such as stop loss orders may not be effective because market conditions may make it impossible to execute such orders. Likewise, strategies using combinations of options and/or futures positions such as "spread" or "straddle" trades may be just as risky as simple long and short positions. Past results are no indication of future performance. Information provided in this correspondence is intended solely for informational purposes and is obtained from sources believed to be reliable. Information is in no way guaranteed. No guarantee of any kind is implied or possible where projections of future conditions are attempted.

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