Trading gold in a Fed tapering world

Tapering of the Fed’s $85 billion bond-purchasing program could start as early as next month, and pessimistic speculation has driven gold prices down to new lows not seen for roughly three weeks. According to New York broker Carlos Santalla, “the downward pressure in gold (COMEX:GCU13) is testament to the belief that tapering is likely to start sooner rather than later,” and many investors are not ready for a sudden change in monetary policy.

As the economy improves and the dollar gains strength, gold inversely loses its value and can become a trap for futures investors who are rapidly selling similar precious metal assets that have little to no yield. Before the news of tapering, investors used commodities like gold as protection against inflation, but now that the Fed is tightening its monetary policy and decreasing the supply of money, interest rates are going to rise and futures will continue to decrease. For example, the SPDR Gold Trust, which dropped 32% this year, so far 2013 is hitting some of the lowest prices since early 2009. Regardless of any further statements from the Fed, a decrease in the government’s quantitative easing initiatives will mean an end to gold investor peace of mind.

So with the possibility of a September Fed taper still on the table, how can a trader speculate on further downside in gold prices?

There are a few ways to do this:

  1. Trade the ETF. There are several ETF products to choose from that offer exposure to the spot price of gold and double and triple ETFs can offer some leverage to investors. However, all ETFs have expense rations built in so they can never track their underlying perfectly.
  2. Gold futures and options. Using gold futures and options offer the inherent leverage and capital efficiency that make them an attractive alternative to physical gold or ETFs. Using futures and options is the most efficient way to take a bullish view on gold in the short term.

With gold futures trading near $1290.00 the options market is implying a move of 95 points by November expiration. This gives us a downside target of $1195.00.  With this downside target calculated we can now look at a trade setup.

Trade: Buying the /GC Nov 1220-1200 Put Spread for $3.20 Risk: $320 per 1 lot Reward: $1,680 per 1 lot Breakeven: $1,216.80

This trade sets up for a great return potential on invested capital with a more conservative target than the options market implies.

Click to enlarge.

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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