The Swinging Pendulum of the Gold Market: How to Trade the Middle
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.
Chart courtesy of QST
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More to come......