Esteemed subscribers, I have a confession to make, which is that I don't know which way the current extraordinarily tight standoff in the Precious Metals sector is going to break, either up or down, and it would seem that I am not alone, as this article in Kitco entitled Analysts Mixed on Gold next week; Technical factors cited both ways makes clear. That, however, does not mean that we cannot protect ourselves from being caught on the wrong side of the trade, and it does not mean that we can't turn the situation to our advantage - we certainly can and we will and ways to do this are the subject of this article.
Rare times like this where the market is in a state of temporary perfect equilibrium and extraordinarily quiet, and indicators are conflicting, are due to a situation where the market is waiting on important developments, such as whether the discordant buffoons in Europe will finally get their act together and do something concrete to stave off catastrophe - if they do the market will likely rally strongly, if they don't the market will collapse - it's probably that simple. This is why the Elliot wavers and other gurus with their predetermined price targets are little more than charlatans - the market is a constant evolving dynamic, with the forces of supply and demand feeding off fundamental developments that in this case are real time. This is why we always remain flexible and responsive to the latest developments.
Amongst a battery of conflicting indicators we have the following - a gold price that has run right into the apex of a Symmetrical Triangle, indicating indecision carried to an extreme, where the long-term trend thus far remains in force with a rising 200-day moving average catching up beneath and suggesting an upside breakout, but at the same time a dangerous bearish gap has opened up between the gold lease rate and 1-month libor, of a similar magnitude to that which preceded the plunge in September. We have a horrible price pattern in silver, a potential Head-and-Shoulders top, with considerable downside risk, but on the other hand a strongly bullish COT structure with a low open interest and a very strong Accum-Distrib line. I could go on, but you get the idea.
Precious Metals stocks are in a state of absolute standoff after moving sideways all year, with conditions now uncannily quiet. As yet unknown fundamentals developments are going to break this standoff very soon now. On the 2-year chart for the Market Vectors Gold Miners (GDX) we can see that a rare Diamond pattern is completing, which we examined a few days back. As we observed then these patterns are usually tops but are sometimes consolidation patterns that are followed by renewed advance.
The 6-month chart for the GDX shows that the Triangle has morphed into a rare "Fish Head" where the oscillations within it decrease at an accelerating rate, indicating a market approaching a state of temporary absolute equilibrium - a situation that can only exist for a brief period of time. The appearance of this pattern is a sign that a big move is imminent. What are the chances of a whipsaw false breakout here? - a breakout in one direction that rapidly reverses after getting a lot of players on the wrong side of the trade. This is considered unlikely in this case as powerful forces trying to engineer such a false breakout would likely trigger such a flood of buying or selling that if they opened the door in one direction they would be unlikely to be able to get it shut again. This is because these Triangles are so tight and well defined that once a breakout occurs a lot of traders will jump down off the fence.
Alright, so what are we going to do about it? The answer to this question depends on what type of investor or trader you are. In any event you should employ a general stop a little way below the lower boundary of the Triangle on the GDX index (or the lower boundaries of similar Triangles in the HUI or XAU indices) and allow yourself to be closed out of pretty much all long positions in the PM sector in the event of a downward break, or if you stay long you should find a way to hedge - Puts are a good way to do this. More experienced subscribers wanting to capitalize on this situation should open straddle positions (a combination of Calls and Puts) without delay on Monday - with a bit of luck the market will wait long enough for us to do this before breakout either way occurs. There are two key points to make regarding this. One is that with the Diamond pattern completing after a standoff lasting nearly a year, we can confidently look forward to a BIG MOVE, so this is rare opportunity to do a straddle which in this situation is regarded as a low risk strategy. The second point is that you may think that buying Calls and Puts at the same time is expensive and incurs the risk of a double loss. You are right, this is so, but there are times such as now when it can be highly effective AND a relatively low risk strategy. Let me repeat that the tight standoff is about to end and result in a big move. Thus, the gains on the Calls can be expected to far outweigh the losses on the Puts in the event that the sector breaks out upside, and the gains on the Puts will far outweight the losses on the Calls in the event that the sector breaks out downside. Let me give you an example. In London in the 80's I did such a straddle in a stock named Trafalgar House a day before its results were due, after it had risen a lot. I bought a line of Calls, and a mountain of dirt cheap Puts. The brokers laughed at me when I bought the Puts, but immediately and nervously raised their ask price 50%. The results came out and the stock went into a decline, slow at first but then it accelerated. Seeing which way the wind was blowing I ditched the Calls for a 50% loss and within a week I sold the Puts for a 1200% gain - too early as a month later they were up 4000%. The point I am making is that if you open a straddle position in quiet market conditions before a big move you can really clean up - and that is just the situation we are looking at today.
Now we will have a look at some candidates for either protecting long stock positions or for making big gains on the upcoming big move. There are two chief courses of action open to those subscribers who are able to trade options, and who have the requisite experience. One is to use them to protect any open long positions from the sector breaking lower now which could trigger a significant drop. In this case the Put options serve as insurance, and the idea when buying them is to select options that are sufficiently "out of the money" that they are cheap, and can be written off as "the cost of insurance", but with a strike price close enough to provide point for point protection soon after a drop commences.
Those who wish to use options now for speculative gain are being presented with a great opportunity at this time, it is believed. This is because a straddle opportunity like this only presents itself "once in a blue moon". A straddle is where you buy both Calls and Puts confident of a big move, but not knowing which direction it will be in. The expected move is big enough to result in handsome gains even after writing off the losing side of the trade. For example if gold breaks out upside from its Triangle it could easily rally to a price above $2000, so the buyers of the Straddle would make say 400% on the Calls and lose the Puts, the loss on which would obviously be more than cancelled out by the gain on the Calls. Vice versa if gold breaks lower and drops steeply. Either way the straddle buyer comes out way ahead. But to make gains like this requires a sizeable move, the probability of which becomes much greater after a long standoff in the market, such as we have just seen. The straddle buyer needs a big move and fast, as if it doesn't occur he will be losing money as the time value of both the Calls and Puts erodes simultaneously. Happily the current situation looks set to precipitate just such a big move soon, as gold, silver and the PM stock indices have been fluctuating in an ever narrowing ranges for weeks - Triangles.
In deciding what options to go for we should avoid anything that is thinly traded with wide spreads. When you are playing the market both ways like this you need as level a playing field as possible. Therefore we will only consider options with sufficient liquidity. SPDR Gold Trust and iShares Silver Trust are perfect for our purposes as they have a very wide range of strikes, high liquidity and very narrow spreads. When it comes to gold we don't really need to look any further than GLD. Suitable options in GLD are listed below...
SPDR Gold Trust GLD $166.40
Jan 168 Call at $4.00
Jan 174 Call at $2.02
for more time...
Feb 169 Call at $5.35
Jan 160 Put at $2.20
Jan 155 Put at $1.18
for more time...
Feb 160 Put at $3.70
As far as silver is concerned a good vehicle for protecting silver holdings from losses, and for speculative gain is iShares Silver Trust which will serve the same function for silver as GLD does for gold. SLV's options have good liquidity and narrow spreads like GLD.
iShares Silver Trust SLV $31.33
Jan 33 Call at $0.99
Jan 34 Call at $0.68
Jan 30 Put at $1.14
Those of a more sporting disposition may want to consider doing options in the 2 times leveraged silver bear ETF Proshares Ultrashort Silver ZSL which has a habit of spiking when silver drops sharply and you may recall that we made massive profits on the last spike in it when silver plunged, selling out right at the top. Oddly, options in its bullish counterpart ProShares Ultra Silver (AGQ) suffer from poor liquidity and therefore cannot be considered - far better to do both sides of the trade if you are a straddle trader, in ZSL, where liquidity and spreads are acceptable. If silver breaks down and drops steeply then ZSL can be expected to spike, but not as much as in September - probably to the $16 - $17 area, but if silver breaks out upside ZSL can be expected to tank, slicing through the support at $11 like a hot knife through butter. Being a leveraged ETF, ZSL reverses rapidly so you need to sell into strength ahead of a reversal.
Proshares Ultrashort Silver ZSL $12.53
Jan 13 Call at $1.20
Jan 10 Put at $0.36
Posted at 10.55 am EST on Sunday 11th December. Addition of specific option trades made at 10.00 pm EST.