The resurgence of gold as a portfolio diversifier has brought in new participants to the marketplace. With the explosive growth of hedge funds and new securities products such as ETF`s, gold futures markets have been experiencing noticeable increases in open interest.
The Chicago Board of Trade has responded by launching electronic gold contracts, which have been extremely successful and have most recently started trading gold options electronically.
As these new security products and hedge funds use the futures markets for speculative and hedging purposes the effects they exert on the market can clearly be seen. This can be witnessed by the steepness and extent of the last spring’s rally and the $155.00 drop that followed.
These new players have brought back volatility, which creates trading opportunities.
Gold has been in an uptrend for the past six years and has recently posted new 25-year highs (see: “Room to grow”).
In the past gold rallies have been met by concerted selling from central banks. This selling has been absent on gold’s recent ascent. As large bank selling has subsided, the steepness of the rally has increased.
Another driver that has accelerated the move is the price of crude oil. The swift appreciation in crude has distorted the relationship between the price of gold and the price of crude. This relationship has averaged 17 to 1 since post World War II. Currently it is running at 10.27 to 1. With the current geo-political situation and the expanding demand base for crude oil, it is gold that will most likely move to bring this relationship back in line.
The current geopolitical landscape commands a risk premium for gold —the exact dollar value of premium is hard to quantify. The turmoil in Iraq, Iran and North Korea and have escalated world tensions. As these problem spots worsen, the premium continues to expand. “Always have enough gold on hand to bribe the border guard,” is a common adage in troubled regions of the world and revealing with today’s geopolitical realities.
“The trend is your friend,” as trite as this sounds is applicable. Gold has been trending higher for the past six years and looks set to move higher. The current economic and geo-political environment favors the long side.
Technically the charts also point to higher prices after recovering from major retracements. A 38% extension of the highs from May 2006 suggests a target for gold between $825 and $850. With this in mind, investors should be long gold.
One way to participate in this volatile market is to use options. In volatile markets were timing can be critical when trading futures, options can help manage risk. Often times in futures trading, a trader can be right on the move but wrong on timing. In this case, options can be more forgiving and allow the trader more staying power.
Another benefit of options is limited risk. When purchasing an outright option or buying a vertical spread (buying a call and selling a higher strike price or buying a put and selling a lower strike price) the risk can be defined and limited. In futures stops can placed but this does not completely limit the risk as markets can gap and stops can be elected far from their trigger price. When purchasing outright options or vertical spreads the risk is limited to the premium paid.
A viable strategy to participate in the recent move in gold is to purchase a call spread. Purchasing options involves the risk of time decay. Options with more time to expiration experience far less time decay than one where time is short. The last 30 days to expiration is where time decay is the greatest. A strategy that could be employed now to take advantage of a large move higher would be to buy a call spread. One that represents good value and a good risk reward ratio is to purchase the GCZ7 700 calls and sell the GCZ7 750. This spread could be done for about $1100 and the maximum profit potential is $5000.00. This represents a greater than 4 to 1 risk reward ratio.
Charles Nedoss is senior account manager for Peak Trading Group.
He can be reached at, Charlie@peak-trading.com, (800) 559-7109.