Gold Market Update
Originally published August 23rd, 2009.
UPSIDE BREAKOUT ALERT: gold is now believed to be very close to an upside breakout to new highs, a development that should lead to a rapid advance towards the $1300 area, and it should be noted that this scenario will not be negated by a brief sharp drop that may be aimed at wrong-footing a lot of traders. The reasons for shifting from our recent stance of neutral/bullish to flat out bullish are as follows... 1. Massive inflationary pressures building as the gargantuan panic measure increases in M0 money supply by the US Fed late last year and well into this year come through the pipe, replicated in other countries around the world although probably not on such a grand scale. 2. strong breakout by US stockmarkets late last week that portends continued gains, confirming the building inflationary pressures. 3. ongoing gains in the prices of other commodities - copper continues to advance, crude oil threatening to break clear above June highs. 4. window for dollar to stage a strong rally believed to be closing, increasing downside risk - it appears that the dollar is to be sacrificed in favor of Treasuries - a quite logical way of reducing reducing the debt burden, even if not entirely appreciated by creditors. 5. significant improvement in gold COT last week. 4. gold's best month of the year seasonally, September, is just around the corner.
There are a number of ways to capitalize on the expected breakout and advance by gold. The ideal method is by purchase of physical bullion, with potential losses from a breakdown being defined and limited by the judicious use of options. Proxies such as ETFs like SPDR Gold Trust (GLD) are perfectly in order, but purchases of such vehicles MUST be protected by options. This is because unlike gold itself, these could crater with very little warning if any accounting or inventory irregularities should come to light. Most larger gold (and silver) stocks are not particularly liked at this point because of the still considerable overhanging supply which may result in them putting in a disappointing performance on the first major upleg by gold out of its 20-month consolidation pattern. This is why on the site we are concentrating on selecting the stocks of smaller gold companies that are just going into production or close to doing so and thus have big upside.
Gold certainly doesn't look like it is topping out against most other currencies. On the Euro chart it looks like it is setting up to go parabolic.
While the factors listed above point to an upside breakout soon, the contraction of gold's trading range as it approaches the apex of a triangle and the resulting low volatility means that more sophisticated traders can positions themselves to reap large gains on the expected advance and at the same time insulate themselves from serious loss by hedging with cheap out of the money Put options. We are in fact in the perfect situation to employ Straddle options which are a combination of Calls and Puts. Normally this strategy is unattractive and risky, due to the fact that if the market moves sideways you stand to lose from eroding time values on both the Calls and Puts, however we are now in a situation where gold has been languishing in a triangular consolidation for about 6 months now, which is rapidly closing up so that a big move is imminent, and furthermore, gold has been stuck in a larger trading range, believed to be a consolidation, for no less than 20 months, which obviously greatly increases the chances of a major trend emerging shortly. For the reasons listed in the first paragraph gold is expected to break out to the upside and embark on a significant uptrend soon, so our strategy is to go long gold, possibly gold ETFs, and selected gold stocks and to protect these positions with cheap Puts, but the possibility also exists for skilled traders to go for a straddle option strategy, the idea being that the gains on the Calls should far exceed the losses on the Puts, the Puts being bought as insurance in case gold breaks down - if it does the Puts should be liquidated once they have made sufficient gains to cover the cost of the Calls. This strategy, which assumes the Puts are not being used to protect long stock positions, could be very profitable indeed in a whipsaw situation, as if the Puts are sold when they have gained enough to cover the cost of the Calls, and the market then rapidly reverses to the upside, which is what we would expect, the Calls will have been obtained for nothing.
The exceedingly low volatility of gold in the recent past, made very clear by the contracting Bollinger Band channel on our 1-year chart, means that option premiums should be low at this time. Furthermore since gold has not declared itself by breaking out of the triangle in either direction, but is approaching its apex in a tight range, it means that both Calls and Puts which are quite far out-of-the-money and thus cheap can be purchased with the reasonable expectation that one side or the other will be well in-the-money after the next big move has run its course.
To conclude: the time is thought to be ripe to go flat out long gold and gold related investments. This is a train you can and should board BEFORE it starts to leave the station. However, there remains the risk that gold could instead break to the downside first but if it should do so there is thought to be a high chance that it will be the handiwork of Big Money deliberately shaking small investors out before a breakout to new highs. Although the gold COT did show a marked improvement last week, Commercial short and Large Spec long positions are still at a higher level than we would like to see ahead of an upside breakout. The latest Silver COT in contrast shows a marked increase in Commercial short positions and Large Spec long positions, adding weight to the argument that we had earlier set out to the effect that Big Money may be planning to ambush the little guy before the Precious Metals start their next major uptrend. Accordingly long gold, ETF, and stock positions should be protected by out-of-the-money Puts (ETFs should in any event be protected with Puts), which are or should be cheap at this time due to the recent low volatility, which need not be in the same security - for example GLD Puts can be used to protect bullion. Straddle option positions are very attractive at this time for traders with the appropriate level of experience and understanding as gold has essentially been in a giant trading range for 20 months, and is approaching the apex of a 6-month long Triangle, making a big move probable soon. In the event of a sharp drop the Put side should be sold once the cost of the Calls is covered - the Calls are then free.