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NOTE: This was posted
for Metal Augmentor subscribers on
October 27, 2009 at 2:10 AM EST. Normally I would reserve this type of
commentary for subscribers but it involves a change in the SILVERAXIS Alert
Flag, so it belongs here. Alas I’ve noted the recent traffic rankings
on this website are down quite a bit — probably as a reflection of my
infrequent posting schedule or perhaps my “doubting Thomas”
attitude about the ongoing gold rally — so I’m not sure what
it’s worth. I suppose we’ll have to wait and see with the full
benefit of hindsight. By the way, I’m going to have another
“contest” shortly for a free Metal Augmentor membership as a ploy
to get some of you to come back and visit more often, so please do.
Last Friday gold
tried mightily to attain a new closing high on the weekly chart but could not
manage it, setting up the possibility, at a minimum, of a normal autumn
correction (as opposed to the abnormal one we had last year). If it starts
this week, such a correction would appear as a “rollover” on the
charts, demanding a drop to at least $1025 gold in order to create sufficient
momentum for a meaningful decline that cleans out the riff-raff and sets the
market on a strong footing to continue its historic rise. We expect Tuesday
of this week to be a critical day for the longs to defend support at $1040 in
December COMEX gold and ideally to attempt to regain the $1050 level. If
these efforts fail, we would then look for longs to start an “every man
for himself” (or woman for herself) exit during the rest of this week. Should
gold close around $1025 or under on Friday, the correction will likely last
at least 2 more weeks with a possible low in the $980 area by the second week
of November.
We give the above
scenario fairly high odds (between 25-50%) and while arguably we are doing no
more than grabbing at straws, we do spend quite a bit of time staring at
price patterns and picking out the best (and worst) technical analysis to
help coalesce our views. From time to time we are even rewarded with being
correct, which seems to be anywhere from 25-50% of the time. Coincidence? We
think not! Compare this to the .000 batting average of the typical gold
pundit who has emphatically declared the “Big One” on about a
thousand occasions in the past few years, only to strike out every single
time.
On the other hand, if
gold is able to shake off the weakness and close the week on a strong note
near or above $1050, there is a very good possibility that next week could
bring new highs in the $1080-$1100 area, which is the level we thought might
be an intermediate top for this historic move above the March 2008 high. There
is of course nothing to definitively say that gold cannot go much higher than
$1100 in the weeks ahead, and there is also nothing that can. It’s just
that we’re working with probabilities (or rather possibilities) here,
not absolutes.
Therefore, due to the
good possibility of a
significant short-term pullback and the nearing expiration of December COMEX
gold and silver options as well as November stock options, we have recently
made prudent additions to our put option positions. In COMEX gold, the 980
and 1000 strike put options, with 4 weeks left to expiration, are both
looking attractive (as in relatively cheap) at recent prices although they
did move up on Monday. In COMEX silver, the 1550 and 1500 put options are the
way to go in our opinion. As we’ve mentioned before, our preferred
strategy with put options at intermediate market tops is to go long futures
once these puts go into the money. If purchased in pairs, we could go long
with one futures contract and let the other put option ride, creating a
potentially very profitable long strangle spread should price volatility
persist into option expiration. Given that a strategy like this only needs to
work once in a handful of attempts in order to “put” us far ahead
of the game, you’ll see us participating whenever the opportunity
presents itself. But, don’t try something like this if you have a
batting average below 0.250, much less if you belong to that certain esteemed
group of gold market experts who consistently bat 0.000. Another way to say
this is that you will be fine as long as you have predicted 12 or less of the
last 4 gold market corrections. After all, even those notoriously bad
gamblers — economists — have been able to predict at least 9 of
the last 4 recessions.
In stocks, we have
bought November put options in the Freeport McMoran (NYSE: FCX) 65 strike,
the Southern Peru Copper (NYSE: PCU) 30 strike, the Teck Resources (NYSE:
TCK) 26 and 27 strikes, and the Agnico-Eagle (NYSE: AEM) 50 strike. We also
have tried and may yet buy Silver Wheaton (NYSE: SLW) 11 and 12 strikes and
the Lihir Gold (NASDAQ: LIHR) 25 strike. These put options in stocks
don’t offer the same leverage as COMEX gold and silver but it would be
possible to use the same strategy we outlined above, going long in the
underlying shares if the puts are in the money. For example, if Freeport
McMoran drops to $60 per share, each 65 strike put option would show a profit
of $460 (1100% return based on a $40 cost for the put). If instead of selling
that put, we were to buy 100 shares of Freeport for $6000, we would have no
downside and the potential to make additional profits if Freeport shares
trade above $65 prior to option expiration. In some brokerage accounts, it is
possible to buy NYSE stocks at 2-to-1 margins especially if they are hedged
by options, so you might be able to control the 100 shares of Freeport for as
little as $2000. Considering that such a situation would be enabled by a $40
“punt”, the leverage is not too shabby.
We should note at
this point that if you are thinking about a speculative strategy such as the
above, it is important to be careful because greed is a very strong emotion
in the leveraged world of options. You should always limit each trade (in
this case, the “trade” consists of the total November put options
in stocks and December COMEX gold and silver put options since they all
expire around the same time) to no more than 3-5% of speculative funds. There
are rare exceptions to this rule, but the present time is not one of them. Strict
position limits is why we insist on at least the opportunity to make 10x
gains or more with option plays. A 1x return might seem decent especially if
you can get that 3 or 4 times a year (which itself is quite an
accomplishment), but even then your return is “only” 12% assuming
you place the recommended 3% at risk each time. Moreover, that 12% return
does not even account for losing trades, of which you will always have plenty
when buying options. All of a sudden the speculative potential doesn’t
look so hot, does it? Yet we are aware of several advisory services that
approach option trading in precisely this fashion.
Notably, closing
prices on Monday for all of the aforementioned put options represent a
potential 7x to 10x return if gold merely pulls back to $1000 assuming the
other metals and resource stocks follow (which is quite likely). Conversely,
paying more than Monday’s closing prices will severely reduce the
profit potential and increase the risk of the trade, so if the market is
falling on Tuesday or later this week before you have established a position,
you should stand clear and wait for another opportunity. The worst thing you
can do is chase prices in a speculative situation. [Note: We actually
purchased many of our December COMEX and November stock put options earlier
on Monday or during the prior week so in many cases we paid less than
Monday's closing price for our positions].
Moreover, you never
only want to buy options in just one company that you think is going to drop
or rise along with its sector. There is always the chance that the stock you
picked will move according to its own rhythm for company-specific reasons. For
example, Teck is quite leveraged and thus we feel it is perhaps the most
vulnerable to a steep price retracement out of all the NYSE-listed resource
stocks. But if Teck announces a blowout third quarter, the share price might
actually jump before a correction begins, which could result in our strike
prices being too far away even if the company does eventually succumb to
sector pressure. As with most things involving money, it is important to have
some diversification. We try to apply this concept to option strike prices as
well so that we have a mixture of higher probability and higher leverage. For
this reason, it might be worthwhile to consider put options below 980 in COMEX gold and 1500 in COMEX silver, but only once you have established cheap positions at
the higher probability level.
It bears repeating
that the opportunity to make huge returns in a very short time can be quite
tempting but we’re not looking for a grand slam here. There will be
grand slam opportunities in the future but this is not one of them. A solo
home run would be good enough at this point as it would add perhaps 20-30% to
our cash position (still around 50%) and that would allow us to make a
meaningful foray into the shares of the many companies we’ve been
waiting on and watching for the right entry price.
In our most-likely
scenario, the resource sector should retrace, well before Thanksgiving, all
of its October gains and probably much of September as well. At the same
time, the option positions we have selected do not need to be in the money to
generate very substantial returns. For example, another move down like
we’ve had on Monday would double or triple the price of most of these
options, at which point half (or whatever portion of them that pays back the
initial “investment”) can be sold with the rest riding for free.
On a closing note,
we’ve reduced our gold and silver positions in our model portfolio on
Monday to their absolute minimum allocation of 20% (10% gold in the form of
GLD and 10% silver in the form of SLV). You’ll never see us below this
level unless of course the United States returns to the fiscal equivalent of
the 1950s. Cash balances are now over 50% with the remainder made up of
shares in companies we have discussed at Metal Augmentor. We believe this
positioning has actually tilted our portfolio to a net bearish stance for the
first time in quite a while. For those who have followed the SILVERAXIS “alert flags” in
the past, this would essentially equate to a RED flag in the speculative
under 3 month outlook, and after a short delay we plan to make this flag
change public. That said, the flag would very likely reverse to a neutral
yellow by the end of this week if long speculators are able to reassert
themselves with a solid move in December COMEX gold back above $1050.
Alas, our model
portfolio employs only outright positions so it doesn’t have the
benefit of generating additional cash from put option gains during a market
pullback. Therefore, subscribers who do have access to put options can
probably maintain a higher invested balance than our model 50% cash and still
come out ahead. Being able to keep defensive cash balances smaller is yet
another advantage to a diligent put option strategy. In any case, we will
have the details of the model portfolio available for subscribers this
weekend. Going forward, we will also have a page on the website that shows
the composition of the model portfolio on a daily basis.
Disclosure: We may
own positions in the securities mentioned and we may buy more or sell them
without further notice. Please avoid trading futures or options unless you
fully understand the risks involved. The contents of this posting do not
constitute investment advice but are rather provided solely for instructional
and entertainment value (comedy for those of you who disagree with our call
on the gold market in the short run). Contact a registered investment advisor
or broker if you need investment advice.
Tom Szabo
Silveraxis.com
Also by Tom
Szabo
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