Gold is considered to be a safe haven investment, but trading gold is often not for the feint of heart. The swings in this market can test the emotions of any trader, and cause ill-advised decisions based on your perspiration levels. “Safe haven” is a term that the media seems to frequently use to describe why gold has risen, but in certain situations, it’s not always an accurate characterization. I will explain what I mean later in this article, but first, let’s take a look at the fundamentals that have been driving gold to new record highs.
I think the major fundamental influences on gold include concerns about global growth and sovereign debt issues. As gold is priced in U.S. dollars, the flow into or out of the U.S. dollar is also a potential influence on gold. When the dollar is strong, it can dampen the price of gold, and vice versa.
Factors that have driven gold to record highs include the following.
- Escalating concern over Greek debt. Greece has been a situation that has not gone away quietly. I don’t anticipate there will be a resolution to the Greek debt crisis, other than the letting the nation default in order to renegotiate its debt. I feel that is inevitable and necessary before the road to recovery begins.
- China giving a lift. It has been reported that Italy has reached out to China to help support the latest Italian bond auction, as well as help support the Eurozone. Let’s face it—this isn’t really new news, but seems to be providing the markets a fundamental lift.
- Pressure on global equities. It is possible that selling gold to fund equity margin calls may be a story circulated by the press again as it was Monday, September 12. if the markets come under more pressure. However, in my opinion, this is not why gold has come under a bit of pressure and has flirted with $1,800 an ounce.
- Deflation???? …. In my opinion, deflation is the hurdle that gold will be facing in the near future. Double-dip recession fears are causing the current pressure on gold, not margin calls, which the media seems to be touting. It is a long-term economic occurrence that could keep pressure on even the most notorious safe haven trademark, and could potentially devastate account balances if this event were to occur for traders / investors who do not account for this possibility. Conventional wisdom indicates investors should buy gold in any time of uncertainty. But now I’m telling you that’s not always the case, and this may one on them. That’s not to say I’m not bullish on gold, because longer-term, I am.
- Volatility. Gold has seen some big price swings from $1,925-$1,705 an ounce; it has been on rollercoaster since August. Given heightened volatility, any further margin (performance bond) increases from CME Group could pressure gold (we saw two in the past month).
I believe there are plenty of reasons to be bullish gold, even given some likely short-term pullbacks. Global uncertainty should continue to cause investors to turn to gold as a safe-haven. As mentioned, that’s not a new trend. I also expected weakness to continue in the U.S. dollar, because of Federal Reserve policies that remain in place to keep us out of dreaded deflationary economic conditions. In addition, we’ve seen continued fund buyingof gold on dips, and a number of analysts are forecasting gold may hit $2,000 by year-end.
Central banks have also been adding to their reserves this year, and if they are buying, that’s a no-brainer that gold is likely to keep moving up.
Inflation, inflation, inflation. At some point, all this easy monetary policy (printing of money by the Fed) will result in inflation. We aren’t there yet, but inflation does present itself, gold has historically been used as a hedge against inflation.
Gold Options Strategy
I get calls from clients asking me whether it’s too late to get involved in the gold at these near-record highs. I want to review a strategy I believe can help individual traders level the playing field with the large institutional traders, and allows you to stay in a bullish position even though the market may experience sizeable declines in the short-term. I use Fibonacci levels to help anticipate appropriate entry and exit points on trades, which I have outlined in the chart below.
I think gold should hold $1,790. If it closes underneath, there may be reason for concern. However, if gold remains on a bullish track, which I think it will, you might consider a bullish option strategy. You could buy a November $1,800 gold call, which expires October 26, 2011. The cost is about $9,000 currently for this option, not including commission costs. This position means you have the right, but not the obligation, to be long a gold futures contract at $1,800, if your option is in-the-money at expiration. You might find that an attractive proposition, considering gold is priced above that level currently, and you’d be getting a better price to buy it. If gold moves dramatically lower and your option is out of the money at expiration, the most you can lose is the $9,000 you paid for the option (plus commission costs).
However, at $9,000, you might find that to be a little expensive. In this strategy we want to minimize the upfront cost of an already in the money position. So to help offset that cost, in this specific strategy consider selling out of the money options to help finance the 1800 in-the-money call.
In this case, you might consider selling two 1970 calls, a level at which I see as a major resistance point. When you sell options, you collect premium and in this case, you collect $6,700 (not including commission costs). It is important to note that selling calls at 1970 means you may be assigned a short futures position if the price of gold is above $1,970 at expiration. It is important to note that even though you are naked one 1970 call, your breakeven point at expiration comes when gold is trading above $2,140. So, at expiration, if the market is above $2,140, you would be experience a loss as if you were short from that level.
Now to further offset the price of the 1800 call, I suggest selling one 1670 put and bring in an additional credit (premium) of $2,000. The chart illustrates that this is well below major support levels, but remember if the market does trade below this level, you run the risk of being long at any price below $1,670 at the time of expiration.
The calculations then work out as follows. You pay $9,000 in premium for the options you bought, and receive $8,700 for the options sold. The net cost basis would thus be $300, not including commissions and any other trading costs.
This is called a ratio spread. You have a lot of room for the market to move to experience potential profits. And, you will be able to remove some of the emotion out of your trading, because even if the market makes a $30 or $40 move in a day, you will not be stopped out. If you believe the gold market will fall between these levels between now and October 26, 2011, I think this is a compelling bullish strategy. For further explanation at which prices bring in potential profit, and more information about the potential risks, please give me call.
One advantage of doing a spread like this is that the margin requirement is typically less than if you were to engage in a futures position. The margin on this spread is approximately $5,000 – $5,500, while trading a gold futures contact instead would require margin of $9,450. You’ve cut your margin roughly in half. Please be aware, margins are subject to change without notice at any time.
This type of strategy may be a new concept to many of you, but it can work for the right investor, with the understanding of the risks involved. This type of spread can be conducted in any market where you are concerned about volatility. You can weather the ups and downs in the market, knowing you have a wide range before expiration.
Please feel free to call me and discuss this topic further or with any other questions you may have. I’d be happy to discuss similar strategies that incorporate mitigating risk and capitalizing on mid-term directional moves, while helping you weather the ups and downs of daily volatility.
Tim Merrill is a Senior Market Strategist at MF Global. He can be reached at 800-326-6266 or via email at tmerrill@mfglobal.com
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which MF Global believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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