We preface this article by stating that we are neither gold bears nor
bulls. We traders and we target trades with the best possible risk reward
dynamics, regardless of market direction. At the founding of our service, SK
OptionTrader, we were bullish on the yellow metal and banked considerable
profits as gold rallied to all-time highs. Beginning in 2013 we took a
heavily bearish view, and again banked triple digit returns on gold as it
declined. Now, we believe we have seen the lows and are preparing to get long
gold once again.
Fear around the effects of China’s currency devaluation has led to turmoil
in financial markets. Equities have sold off, bonds have rallied, and
volatility has spiked. The medium term future of US monetary policy has been
thrust into darkness as concerns around the economic outlook have risen
rapidly.
As a result of the change in market dynamics we believe that gold has the
potential to rally sizeably from here and that there is the potential for
gold to challenge both the medium and long term downtrend lines. This means
that the medium term lows around $1050 are highly unlikely to be visited in
the coming months and we intend to take full advantage of that.
Gold has failed to rally on key bearish events
Gold and US real rates have long held an inverse correlation. When rates
were cut and the Fed embarked on massive QE, gold rallied to all-time highs.
Once the Fed implemented QE3 the economic outlook improved. This meant that
more QE would be unnecessary and that the current measures would be tapered
off. While this took place gold fell back from its all-time highs, entering a
bear market in April 2013.
In December 2015 the Fed raised interest rates for the first time since
2006. This began a new tightening cycle and was accompanied with overall
hawkish sentiment and dot projections that indicated the Fed expected another
100 basis points of hikes would be required in 2016.
This was the most hawkish monetary policy since action taken in nearly a
decade and should have been heavily bearish for gold. However, the yellow
metal failed to break through support at $1050 and did not even challenge the
longer term support level of $1030.
At the beginning of this month the employment report showed that nonfarm
payrolls had increased by a considerable 292,000 and that previous two prints
were revised upwards by 50,000 new jobs. This is the type of improvement in
economic data that the Fed would use as good reason to hike rates again.
Therefore the print should have sent gold lower, as it made further hawkish
action more likely. Yet, gold maintained its strength on the print and has
failed to break support at $1080 in the week since.
What will drive gold down?
If gold cannot break to new lows on a hiking cycle and continued economic
strength, then what will drive the metal lower?
Fresh ECB QE is likely to be bearish for gold for the
same reasons that QE3 in the US was. However, the ECB is unlikely to announce
new measures at their meeting this week. This means that the earliest likely
target is their March meeting. Therefore before March 10th there
is unlikely to be a major catalyst to drive gold down outside the US.
The next Fed hike has the potential to push gold lower, as it will drive
home the point that rates are rising and that we are now in a tightening
cycle. This means we must ask, when will the Fed next hike?
Given the current financial turmoil on the back of China’s currency devaluation,
it is near certain that the Fed will not use their January meeting to raise
rates again. The mayhem also means that March, which we had previously
believed to be highly likely to hold the next hike, is much more uncertain
with market pricing now shows the chance of a March hike to be just under
30%.
It is highly unlikely that shocks that cause other markets, such as
stocks, to fall would cause gold to fall also. Gold is a safe haven asset,
and therefore unforeseen events are much more likely to drive the metal
higher than lower. Therefore, our bearish factors are limited to monetary
policy. Given that major central banks are unlikely to take action that will
be bearish for gold, there is no significant catalyst to drive gold lower
this month, the next, and at least the opening weeks of March.
Does this mean gold is going higher?
Just as the lack of a bullish catalyst will not cause gold to fall, the
lack of a bearish catalyst does not necessarily mean that gold will rally.
However, in this case we believe that there are a number of reasons that lead
us to the view that gold prices are heading higher.
Firstly, there is the discrepancy between bond prices and the price of
gold. Bond prices have risen as the chances of a Fed hike in the next three
months have decreased. Gold followed bonds higher initially, as per their
long term relationship, but the metal has failed to continue the upward
movement.
As a result, the current bond market indicates that gold is in fact
heavily underpriced and should be much higher. Based on the last close for
SHY, an ETF tracking 1-3 year Treasury Bonds, gold should currently be
trading above resistance at $1150. However, Friday’s close puts gold at
$1088.60.
This discrepancy is too large to be just noise. Therefore either gold
prices must rally or bonds fall. For bonds to fall there would have to be an
increase in the expected probability of the first hike coming sooner. This is
means that concerns around China’s currency devaluation would have to
dissipate, markets would have to calm and equities begin to recover. For this
to all take place before the March FOMC meeting is highly unlikely.
A much more likely scenario is that concerns will persist for some time,
and that markets will recover more slowly. This means that bond prices are
much more likely to rally than fall from here. This in turn means that gold
is likely to rally more than the $60 it is already under-priced by.
Therefore, the next $100 move in gold is higher, not
lower, and is likely to take place inside the next two months. This means
that the medium term lows are in and that it is time to get long gold, or at
least cut any short exposure.
What is the trade?
There are a number of ways to access movement in gold. One could buy GLD,
the ETF that tracks gold, but this is not the vehicle lacks any leverage to
the metal. One could by gold stocks, but given the market dynamics there is a
strong argument against this.
Suppose that one held the view that gold was going to rally due to
continued financial market mayhem, as we have covered above. Then surely they
must also hold the view that equities will continue to fall. It is much more
likely that gold mining stocks will be sold off as a stock than bought into a
rally as a gold vehicle. This means that overall gold stocks are a poor
investment in the current market conditions and far from the best way to
access the coming rally in gold.
We believe the best way to gain leveraged exposure to this rally in the
yellow metal is through options. A fine-tuned options strategy here can be
geared to take advantage of the exact market situation and gain significant
leverage to gold while keep risk limited.
A strategy that stands out for us immediately is selling vertical put
spreads on GLD. Our analysis shows that a bearish catalyst for gold is
unlikely to be in play until March, so we will look to options with March
expiries. We will now consider such a trade with strikes around $100, which
corresponds to $1050.
If gold falls less than $40 between now and March when these options expire,
then the trade will make its maximum profit. While this is not a heavily
bullish trade and the upside is not astronomical, the trade still has very
positive risk reward dynamics. Even if market conditions change rapidly and
begin to recover, this trade is still likely to bank its maximum return.
We are also considering much more bullish plays if market dynamics
continue to become more bullish for the metal. Should gold break through the
long term downtrend line, currently just below $1200, then we will look to
take advantage of the new bullish trend by opening much more aggressive
positions. If you wish to see exactly when we execute these trades and how we
trade rising gold prices in the future, please subscribe via either of the
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