A Bubble in Gold?

At times, it’s hard to take a step back from all the excitement and make a rational decision, which might be the opposite of what the crowd is doing and thus seem like the wrong decision to make.

The markets are an exceptional breeding ground for this type of “crowd” behavior. Because the markets are driven primarily by two very strong emotions – greed and fear – and they are centered around gaining or losing money, which is at the center of most of our lives, creating hype and excitement is easy. The flow of information via the Internet, TV and radio amplify the speed at which data moves and often increase the velocity and severity of hype and extremes in the marketplace.

I cannot tell you how many times I have heard people talking gold this past month. From cab drivers to waiters and just about everyone in between, the conversations I have had with people have gotten my mind going.

I saw that they have launched a Gold ATM in the most expensive hotel in the world (the Emirates Palace in Abu Dhabi). This machine lets you deposit currency and get gold coins of different weight in return; the machine does charge a fee to dispense the commodity.

Even Kmart and Sears (offspring of Sears Holdings Corp. [NASDAQ: SHLD]) are in on the action, offering customers a kiosk in which they deposit their “old” gold and silver and get a check from a company called the Pro Gold Network.

This is not to say that you should just go off and sell gold if everyone is talking about how expensive is has gotten. There are a multitude of factors that push and pull on the price of gold, many of which are quite complex as they involve the credit, health, and currencies of many countries. Historically, gold and the U.S. dollar have had been negatively correlated on average.

One big reason people justify the run up in gold recently is devaluations of currencies around the globe. The U.S. dollar might be doing well vs. the Euro right now, but that does not change the fundamental issues with the currency. The U.S. government is printing a lot of money to cover its obligations. Just because Europe might have to print more doesn’t mean that gold should trade for fewer dollars per ounce. The logic goes that if every country prints more money to get through their troubles, then currencies as a whole are worth less in relation to hard assets: food, gold, etc. Oil and copper fall into this camp in many ways. However, since demand for things like oil and copper is so much more sensitive to economic activity, they can fall in price in this situation when there is a fear for a big slowdown.

I must admit that I am not a global economist, nor do I have all the answers as to why gold trades where it does (I don’t believe anyone can make that claim). As a short-term, statistical options trader with a technical focus, perhaps I view the markets in a different way.

Looking first at the price chart of gold futures, I echo Dennis Gartman’s sentiments that gold is overbought here and in actuality, I mentioned this at the top of gold’s recent run on May 12.

When gold broke above $1162 an ounce, then $1170, one would expect a small technical run up, perhaps to $1180. The issue that I had was not only the speed and distance at which it ran, but what the dollar index was doing in relation to the move – it was rallying with it!

The dollar index (DXY) is trading back at its elevated levels of November 2008 (around 86.54). Back then, the U.S. was in the midst of a financial crisis and gold, which is also supposed to be a safe haven, was trading around the $770 level. One would think that with the U.S. financial system on the brink of collapse, there would have been a rush to gold (I guess folks just stuffed the mattress). From that point forward until about March 2009, gold and the DXY moved higher together.

Today and for the past couple of weeks, the DXY and gold have been both moving higher (parabolic is the term being used). Based on past correlations and statistics, I do not believe this price action is sustainable for long. While one could argue that the world is flocking to gold to hedge against both weakness in Europe and potentially in our financial markets, if the dollar continues to move higher, statistics suggest that gold moves lower and falls back in line with its negative correlation to the dollar.

That is not to say that in the long term gold will not remain a “global currency” and offer diversity in your account, nor do I believe that gold will fall much below its 20-day moving average at 1190.

Last Wednesday on CNBC, I discussed one particular options strategy for bullish long-term traders who wanted to reduce their sensitivity to gold’s short-term oscillations.

The strategy is a risk reversal, which is the sale of an out-of-the-money put and the simultaneous purchase of an out-of-the-money call. The trade that I was examining was on the SPDR Gold Trust GLD, which is an ETF trust that tracks the price of gold.

GLD was trading around $120 at the time, and this particular trade involved selling the December 113 put (they quoted me wrong) and buying the 134 call, for a credit of $1.50 or so. The risk to this trade is the short put strike, minus the credit received (in this case $111.50). The risk reversal upside is unlimited above the long call strike with the rise of the price of GLD. If GLD just stays between 113 and 134, you will retain the credit of $1.50. I chose to bring up this strategy because if you are bullish on GLD but want to lower your overall breakeven, a risk reversal can be a strategy to employ.

For traders who have the opposite view and are bearish, risk reversals can be used to create a semi-synthetic short stock position, by doing the opposite action with the purchase of a put and the sale of a call (typically they are both out-of-the-money). One thing to keep in mind is that with a bearish risk reversal, you are short a call (in addition to your long put) which gives you theoretically unlimited loss above the short call strike. Margin requirements may be different as well, even if the same strikes are used because of the uncapped risk. The maximum you can make is the long put strike plus the credit received or minus the debit paid for the spread.

Photo Credit: PinkMoose

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