December Fed looming, Gold stands at an important inflection point.

Two posts ago, on November 14th, Gold Returns to Critical lows below 1100, I wrote the following.

So now, gold has found some buying around 1073, but has shown a lot of difficulty picking up any steam to push it towards 1100. This is an incredibly significant battle that the longs and shorts will fight out in this range. 40 dollars higher gold looks like a commodity that is finding real support and an ability to hold up dramatically well amidst all of the worlds commodity selling. 25 lower makes gold look very unattractive.

A month later, this still holds true. Despite a temporary move down to 1045, we are more or less in a range. Broadly speaking, that range has been 1060-1080. I think the levels, at least on the upside are becoming a bit clearer, and we can begin to focus on critical price points in anticipation of this week's Fed. 

You might expect I would show a short term chart to discuss these levels, but I believe they apply to much bigger levels. So, let's look at my favorite chart in gold because it tells so much; the three year daily.

The slow moving downward channel gold has been in for years is crystal clear on this chart. 

What I will mention from here on out about this chart is not technical analysis; it is just gold analysis. Even if you have never looked at a chart before, you can see that gold has demonstrated certain clear price pattern characteristics when approaching the extremities within the range.

Notice the very first low in July of 2013. That was the establishment of the lower line of this channel. How long did it spend there? Not long. It quickly rallied up to the top of the channel. Then revisiting this new down channel in December 2014 it rallied relatively quickly to the top of the channel. You can see how this pattern continues throughout the years.

Why is this so important?

Look at where gold is now. It is hovering at the bottom of this lower line. The last time it hung out on the line was this summer after the overnight 50 dollar drop to 1080. It consolidated before rallying nearly 100 dollars. Could we be seeing something similar here? My major takeaway from this chart (which is why I always come back to it for reference) is the speed at which gold rallies off of the lows. It is one of the reasons one might understandably adopt a strong bullish stance. In the last few years, betting on rallies off of the lows of this line have proven to be very profitable.

I will come up with the next argument for the bulls in a few, but there is also a way to see the above chart in a critically bearish light. 

Forget lines on a chart for a second and think about what it means when consolidation occurs at a certain price level.

Consolidation takes place at levels where buyers or sellers at a given point in time don't strongly outmatch the other. There is some buying and some selling, but not enough to push a market heavily in either direction. Over time however, when either the buyers or sellers throw up the white flag, the interest on one side of the market gets cleared out. This allows for a potentially accelerated move once the consolidation has commenced.

If you take a look back at the chart above, gold is consolidating along that lower trendline. Last time it did this it rallied 100 dollars in less than 2 months. So what is potentially bearish? The Speed at which gold sold back off  to here following that rally.

Below I am going to reinsert the same chart above.

Now focus on the lower trendlie. Notice that following December 2013, gold did not interact with this line again until a full year later. In July (only 7 months after gold revisited in November 2014) gold came back retesting the 1080 area. The latest consolidation that gold has been experiencing began in November, and has continued to consolidate for longer than at any previous time gold traded along the line.

There are two elements of this price action on the longer term chart that signal the potential for a strong down move. First, the time intervals that gold is interacting with the bottom of the downtrend are shortening. The return more quickly to this support line shows that rallies are fading more quickly across the time frame you see above. Thus while the market has clearly shown strong buying off of this level, the bull party seems to be ending more quickly.

If Wednesday's Fed decision leads to a break of this line on the downside, I think it opens the door for at least 100 dollars in downside. I would consider a break of 1055 as a true break of this line. The longer a line has held as support, the more likely a break of that support is to lead to swift down move. In the case of gold, a break of support would be confirmation that years of efforts to rally have failed.

Finally, I'd like to focus the other line you see above. Below is gold for the last 10 months or so.

This line you see slices down the middle of the down channel we have been looking at. Notice how the line served as resistance in May and June. You can see how precisely this line served to stand as resistance over the course of the last 8 months. The break above the line led to an accelarated move higher; and soon after, an accelerated down move back to the line. Now, as you can see, gold is consolidating below this line. The last time gold broke above the line in early October, it rallied 60 dollars rather quickly. While chartists might deny the validity of this line, I have more reasons for focusing on it. I have noticed that options demand begins to flip (calls get bid above it, puts get bid below) as gold's price relative to the line changes. Markets are not science. There are clearly others in this market who use this line as a guide for future price, and that is enough to command our attention.

It is rare you get a chance to see so many of the price patterns and trends converge at critical points simultaneously. Right now, as I have tried to convey in this post, gold sits in the middle of some very significant cross currents. It is probably not a coincidence that these cross currents are meeting head on in front of the big December Fed announcement. As it stands there is a greater than 70% chance according to markets that the Fed will raise. So, gold finds itself at a major decision point as markets approach the event (potential rate rise) the markets have been waiting for for years. A break higher opens the potential for a yearly close in the 1180-1200 range where gold has spent so much of its time. A break lower opens up the door for new multi year lows. Even if there is not a big move on Wednesday, there will be potential for big moves in the coming days and weeks. Big events like this tend to exhaust either buyers or sellers. Even if the move is not immediate, the potential for 50+ dollar moves over a 1-2 day period will increase at such a point of buying and selling cross currents.

Wishing everyone good luck this week; I will try to write next weekend and discuss the events of the coming week.

-Ben 

Gold Quietly Breaks 1050

The dollar is what is ruling these markets right now. For the time being, the gold price seems inextricably linked to the dollar. Higher dollar, lower gold; and vice versa. 

There have been some buyers coming in in gold this week, but the dollar spoiled their plans starting around 5 this morning. Bad European economic data caused the dollar to rally. The dollar rally extended at 8:15 when the ADP preliminary employment number came in better than expected. The dollar continued making new highs as Janet Yellen spoke in the afternoon. By the end of her speech (which my angry colleagues tell me I am lucky to have not listened to) the dollar had given up all of its gains, even dipping back below the psychologically important 100 level on the dollar index.

The one thing that has actually been clear in these markets is what data is bullish and bearish for the dollar index. Bad Euro economic data is perceived as bullish dollar. Bad Euro data increases the perceived likelihood of European QE, which would put pressure on the Euro. Positive news in the US (good jobs report) increases the perceived likelihood that the Fed will raise rates later this month. Since there is at least a literal connection between interest rates and the economy, positive US data makes it appear that the Fed is more likely to raise. This, in turn should be bullish dollar.

But what happened this afternoon? As my friend put it, "She made it seem like they were going to raise rates, and the dollar rallied. Then she started talking about what might happen after that, and I just got confused". Apparently, whatever confusing words she used were enough to bring some selling into the dollar, and gold managed to hold a low of 1049.4.

I find it interesting to note that the stock market took a turn to the downside after her confusing speech. I apologize for having not listened to the speech I am referencing, but I have been confused enough by her in the past, and will take people at their word when they tell me she made things unclear. The stock market does not like this uncertainty. We have seen this before. "Raising rates" is not necessarily enough to derail the stock market. We know this because stocks have rallied as the perceived likelihood of a rate raise has increased in the past few weeks. But market uncertainty about the message being delivered by the Fed is a different thing all together.

At this point, most market participants are banking on a December rate hike as an inevitability. A rate hike is thus largely priced into markets. The question will be, how do they describe their future intentions. If for some reason they don't raise rates, gold could see an epic short covering rally. But my contention at this point is that a rate hike does not imply lower gold prices. It will, ONCE AGAIN, be in the language that is used.

I am not much for giving out gratuitous advice, but I'll make an exception this time. Try to go into the announcement flat if you can. That is my game plan. Over the past two years, I have seen what seemed so obvious NOT work on these announcements and major events. I have personally put on what I thought were well thought out positions into these kinds of events, only to lose a month of hard work in minutes. I know, I am not alone on that one.

One of the reasons the risk is so great right now is the general lack of liquidity that is so pervasive across markets. I will write more on this "fake liquidity" next time, but I have been watching the liquidity dry up in the gold futures and options markets for some time now. It has been getting progressively less and less liquid. Take today in gold for instance. ~4500 lots traded on what was clearly a stop getting run. The seller left 2000 lots (offered on the screen). After a few minutes of futures silence, buyers took the seller out. Then, with the exception of one small blip, there were no orders to be seen. One would think that a 6 year low might interest some participants. It didn't. This is not the first low gold has made of late, nor is it the first time the participation following such a low has been a complete dud. To my mind, a multi year low would be reason for interest to pick up, but the volume is telling us otherwise. Rather than watching futures change hands throughout the day, you are seeing intermittent volume spikes, followed by silence. This is the ultimate sign of illiquidity, or at least, lack of participation. If a size player is caught of guard at an illiquid time, it increases the likelihood of a gap move. If you want to hold positions into the Fed announcement (or any time leading up to it) just keep in mind that getting out may be tough if it doesn't go your way. 

This Friday is the jobs report. As a colleague reminds me, trend changes in gold tend to begin on NFP days, and on Fed announcements. We will see how it plays out, and I will write more following Friday’s action.

Good luck,

Ben

Gold Returns to Critical lows below 1100

Gold managed to get a lot of people excited over the course of the last few months. Following the late July dip to 1080, it was unable to make any further progress to the downside. 1080 became major support, and the metal managed to rally over 100 dollars off of the lows to 1191. Then, in the course of about a week, all that hard work was undone, and gold is back near the lows of 1080, and mere tics off of making a multi year low at 1073.

There are a few interesting things to note about what has gone on for gold, and how investors are approaching it. Interest rates, or more specifically, the expectation of a rise in interest rates has been the main driver of price. If you take a look back at gold’s price action in the last two months you will find that one basic rule holds: Expectations of a rate rise leads to gold selling, when the expectation is that a rate raise will be pushed further into the future, it gets bought.

The NFP on Nov 6, which came in better than expected, provided the impetus for sellers to knock the metal below 1100. The idea is, better jobs report means the economy is better, and therefore interest rates are more likely to go higher. The logic is not really logic at all. Sustainable jobs are not created from twenty five point raises or decreases in interest rates…. but the soundness of the logic behind interest rate moves, and gold’s reaction to them, is not our concern. We just need to know how gold is perceived at a given time, and what drives investor sentiment towards it. Lately, it has been all about interest rate expectations.

I found it very interesting to learn that the managed money crowd has been behind a lot of the selling. Take a look at the Nov 3 Commitment of Traders.

Notice The -30,958. That would indicate the amount of futures that the longs in the managed money category got out of during the week. I read this as showing that managed money longs bailing marked gold's last gasps in the 1180-1190 area. Had gold been able to recapture the 1180 area and consolidate the chart would look far different than it does right now. My view is that "managed money" is using gold as a proxy for Fed hike expectations, and the market is moving largely off of that view.

Wednesday, November 4th the Fed released their minutes from the previous meeting, and the general consensus was that the tone in the meeting was hawkish (expressing a greater likelihood that a rise in rates was imminent). The Friday jobs number helped to support that hawkish outlook…. Good jobs, less reason for the Fed to change their hawkish tone.

Where from here? Gold made a very interesting efforts at the lows at 1073. Unable to even make an effort above 1090, gold found itself retesting multi year lows.

 Note: Gold made highs near 1191 in the week previous to this chart, and likely marked the levels where managed money started selling. The selling was reinforced with the first big red candle you see at the top of this chart.You will notice that selling came in after 2pm on Wednesday afternoon, just after the Fed had released their minutes. 

Look at the volume on the bottom of the chart. You will notice that the the big down candles tend to correspond to high volume the whole way down, showing real selling. On Thursday however, there is major volume on a green candle at the low of 1073. Consider the longer term chart to see why this level is so significant.

Look at gold from 2007 to now above. As I read it, someone looking to get short futures on these lows would likely be targeting ~1000 dollar gold, near where the old tops from 2007 should serve as support. But those shorts did not get their way on their first try last Thursday. As mentioned in the short term chart above, real volume came into buy at 1073, and defended the previous low. The shorts cleared out quickly as gold managed to rally back nearly 15 dollars, likely representing shorts giving up on their immediate plans to capture such a drop.

So now, gold has found some buying around 1073, but has shown a lot of difficulty picking up any steam to push it towards 1100. This is an incredibly significant battle that the longs and shorts will fight out in this range. 40 dollars higher gold looks like a commodity that is finding real support and an ability to hold up dramatically well amidst all of the worlds commodity selling. 25 lower makes gold look very unattractive.

Short term directional trades don't make sense in this kind of range. If you want to play long or short, I think you need to be working with 25 dollar wide stops and looking for a big move in either direction. If the long/short battle in this range appears to be clearly going to one side, it may be worth it. For now, we will wait to see what this Wednesday's Fed minutes reveal. We should be looking for any big volume that might come in and use it as important information in getting a sense for the bigger picture in the gold market.

In looking back at what I wrote I had to adjust the 100 handle on a lot of what I wrote. It is so easy to get confused as so many of the numbers 100 higher have such similar to the significance 100 lower (1180/1080 especially). Good luck trading and as always, please feel free to share any questions, comments or critiques.

All the best,

Ben

The Liquidity Illusion

“Tighter markets will lead to more liquidity and more efficient markets”.

Maybe, but so what?

At any given moment you can look at the options boards for most of these options and get a tight quote, probably much tighter than you would 5 years ago. While that is nice, it is not clear that it does a great service for the “efficiency” of markets. While the market is tight, it is prone to change more drastically, more quickly as a result of lower volume.

Take for instance what has gone on in gold options in the last week. Call skew (the difference in volatility that a call option is priced at vs the at the money vol) is the highest I have ever seen. That includes the call skew when gold made all time highs at 1900.  The degree of movement in call skew, on a mere move to 1150 on October options expiration took all of us by surprise. While it might signal some short term bullish sentiment, it is being priced as if gold is going to 1300 some time soon. That seems a bit optimistic as 1220 should serve as strong resistance on the longer term.

As an options trader, it is important to keep a close eye on size options orders as they may be indicative of a shift in sentiment. My view so far is that while rallies to the 1220-1230 level are not out of the cards, moves above that will require a complete shift in sentiment toward gold. At that point, we might see the beginning of a major bull market. But we are not there yet. 

In the ~ 3 year daily chart above, you can see that gold is still in the middle of the longer term slow moving downtrend. The significance of this 1220-30 area (and perhaps up to 1250 depending how you draw the downtrend line) is that a breach of it would indicate a break of this long term down trend. 

If we use the chart as our guide, we can certainly see that bulls might have a decent reason to get bullish. But it is not the most bullish setup anyone has ever seen.  You can see the challenge in predicting the change in skew in calls in gold. We are in the middle of the range, so we cannot get aggressive with our calls either way. If that is our attitude (rather neutral on market direction) then we certainly wouldn't expect call skew to blow out like this. We always need to pay attention to orders, because they could be an indicator of things to come.... but there could be other reasons for this massive move in call skew on a historical basis.

Liquidity.

The locals, options traders who historically traded their own books, are dying like flies, but have not adjusted their mentality to the new realities of the market. I am one of these unfortunate souls. In an effort to be optimistic we remind ourselves of how much money we can make when things go awry. But this time IS different. While we have always been the less capitalized on an individual basis, we are more commonly becoming less capitalized as a group. The advice and thoughts I have given this site and my close friends has been net profitable over time. But that doesn’t mean that those who listen to what I have to say, or even that listening to my own good advice will remain profitable.

Options prices are dictated by 2 things. The performance of options, and the price people are willing to pay, or sell options at. This site has made the point that volatility is underpriced in the gold market, and has been over a 2-3 month time frame for the last few years. How then could a trader who is long options lose in this market?

LOCALS, aka THOSE WHO VIEW THEIR JOB AS GETTING PAID TO TAKE THE OTHER SIDE OF A TRADE, ARE AT THE MERCY OF THOSE WHO HAVE THE REAL MONEY.

While I feel very fortunate to have a backer who will risk his personal capital on my investment decisions within the COMEX gold market, I cannot pretend to be more impressive than I am. Because we are small, my future is highly dependent on the big players’ willingness to put on trades that reflect the nature of the market, not its liquidity.

I do not expect the readers of this blog to do research on options pricing and how it resembles future pricing. It takes a lot of time to understand this market, and once you think you do, you will often find yourself disappointed.

As such, I’m forced to repeat the same thing I’ve been saying for some time. YOU CAN WAIT FOR BETTER OPPORTUNITIES.

It has been a while since I have written about the gold market. Here is what has happened since I last wrote.

My partner Georgi and I have been completely on top of price action. We have been so right that my close friend, who had been asking about our outlook, thanked us for putting him into so many good trades.

This is not a self-congratulatory comment. I have had my worst performance on an options trading basis since I got my own book two years ago. I have been more on point with respect to price movement than I have been in my career, and I’ve lost more money in that period than I ever had over a similar time period.

How to reconcile such a situation? On some level I feel like a genious; but my P/L makes me feel like an idiot.

While I wish I had made what I would expect given my options positions over the last month, I have felt this strange sense of optimism. I have realized that my current business model is less effective than it was two years ago. I realize the market has changed. I only write about it because I hope my readership (however small) might gain some perspective from my experience.

Money moves markets. Retail, small companies, and individual traders have a relatively small amount of money. While we might be right in calling ourselves “sophisticated” we are still relatively poor. Locals like myself historically profited from their understanding that curves would come back into line over time. If a fund came in and paid for an April 1250 call, selling it and buying a front month 1200 call would be profitable in the course of a day or 2. In the current market environment, the person who put this trade on might find themselves surprised by the profits that are NOT flowing into their account in the short term.

In the current environment, it might take a month to recognize the same profit. If a local is poorly capitalized relative to the initiator of the trade, they might be forced to puke out of their trade before recognizing the profit they would historically come to expect.

Welcome to the new market.

There are fewer participants available to take the other side of real orders. When a trade goes against the locals, they have to take their trades off too soon. Bottom line? Being poorly capitalized relative to the major players in a market makes for big challenges ahead. This was probably always true, but now, the money that could be made trading throughout the duration of such a trade is less than it has been historically. As such, less capitalized players, with backers who need to justify their own investment in their traders, are in a challenging place. Being right is not a precursor to making money. Options prices are more often controlled by the supply demand of the market, and as the “local” becomes more obsolete due to their capital constraints, accurate assessment of price movements have a smaller impact on the profits one can expect.

The conversation as it started was focused on the idea that it is dangerous to invest in options when the volatility of those options can be so drastically impacted by the supply/ demand concerns of the market. This is the take-away that I hope all readers remember. I have been right at an all time high rate, and profitable at an all time low. It is not because I have put on a bad position. As mentioned, such a position historically was the desire of all traders. As I watched myself be correct, I watched the losses pile up. It was a sobering lesson that the people with capital, and their choices about which part of the curve to invest in, are more important than my own opinions about the market, even if my expectation are fulfilled at an impressive rate.

Readers. Please, do what any self loving person would do. Look out for yourself. Don’t get too heavily involved in markets when being right doesn’t mean being profitable. We constantly make bets on things that have happened historically, but have no fundamental reason for happening again. Don’t bet on the latter. Patience is best for this (and probably all other markets) market. While liquidity, or the lack thereof, despite “tight markets”, is a great reason to fool us into believing we can be profitable on a basic understanding of the market….we have to be smarter. I am a firm believer that the investor who makes fewer bets, and only when they have strong reasons for making such bets, will be successful going forward.

If there is one take-away from this, please let it be that being right is not the same thing as being profitable. I have a million things I could write about with respect to gold, but it is not worth writing. It is simply not an asset class that any investor has a great reason to go either long or short. Let us wait until that changes, and we can discuss why. Until then, remember; you are never in a rush to take a stance, and if you feel rushed, it is best to step away until such urges go away.

All the best,

Ben Ryan

New range established, tread carefully and wait for clues

There are three types of volatility: Implied, realized, and future. Realized is a measure of how much movement there has been during some time period in the past. Implied volatility is the price of options now, which is in some sense a forecast of what future volatility will be.

As a full time options trader, I spend a lot of my time dedicated to searching for patterns that give me hints of what future volatility will be. Looking at the charts and order flow among other things, I use the price of options and my expectation of potential moves to allow me to enter into a trade.

Take a look at the chart above. This is the 9 month daily chart of gold. In January gold made a high of 1307. It sold off rather quickly to 1142 (165 lower, or about 12%) in the course of about 50 calendar days. Take a look at where gold options are priced.

Gold implied volatility is currently trading around 16.5% for options expiring in 60 calendar days (November exp). If memory serves, volatility was priced similarly to where it currently is when gold was trading 1300. As I write, the 40 dollar lower put in gold expiring in 60 days (the November 1095 put) costs about 15 dollars. If it were to be compared to the equivalent put when we were trading 1300 in January, this would be approximately the 1260 put. That move (1300 down to 1140) took place in 50 calendar days.

Here is the trade in retrospect:

15 dollars of premium spent; if the put goes in the money and you cover at expiration, each put you bought will be worth the strike price minus where gold is trading. So, in our example case, where gold moved from ~1300 to ~1140 in 50-60 days, we buy the 1260 put for 15 dollars. On expiration, we are trading around 1142. (1260-1142=118). You spent 15 dollars for a trade worth 118, so you make (118-15) 103.

As a high schooler and college student I played poker as a means of affording some basics. I would rarely play games where I won or lost more than $1000, but it was my young version of trading. Poker taught me one incredibly important thing that I use in my job to bring me back to reality. If you know the implied risk reward of a situation, and understand some basic math, you can become a winning player. Whatever noise markets are blasting in our ears, we must ask ourselves if the risk reward makes sense. If we are not convinced that it does, or that a trade makes sense but comes with a caveat, it is not worth doing. 

In our above example, you would have made a return of approximately 103 dollars on a bet that cost you 15 dollars. You could not lose more than the $15 you put up because you were the buyer. So, you made 103. To calculate the risk reward, we should ask what the number of outcomes like this we would need given this price for the option to break even.

Put more simply: we bet 15 dollars; we made 103. (103/ 15 = 6.8) So if you had an outcome this favorable one out of every 6.8x, this bet would be fairly priced. (6.8x you pay 15 dollars, so you spend 103 on making the bet, if you win once in those 6.8x you will have won what you paid to enter making it “fairly priced”)... there are more outcomes than this, but if it is a move hard or sit scenario, this kind of math is more applicable than would be in a whippier market like crude.

I will not say what makes gold options fairly priced; but as an options buyer you can wait until situations are favorable from a risk reward perspective given your understanding of historical pricing. You are in no rush to make bets. If you are, step back, that kind of mentality is what allows the options sellers to hold onto their profits despite selling vol many times in the last year below where vol was realized.

All of the charts I show are in an effort to show and determine what I see as patterns of buying and selling. If we can find lines, however random, that indicate to us the potential for consolidation, it makes the prospect of owning options all the more dangerous. If you paid similar prices for the option we just discussed from any time between late March and June you probably lost all of your premium. To make on that trade, your timing would’ve had to have been perfect. 

Creating a fair price for gold options over a 4 month period can be very tricky. The market can sit still for months and then move quickly all at once. Most of the time it is actually overpriced, but the times it is underpriced, it is drastically underpriced. If you look at the chart, and assumed you could not time things, but rather made the same bet time and time again, you probably made a little bit over time. You would not  have made enough to justify seeking out trades like that. It is the most difficult discipline we need to keep when trading gold. Even if we are right that gold is going to collapse or rally 100s of dollars, owning options gets expensive if we are right a little bit too early.

The longer term (not seen here) chart seems to indicate that gold remains in a downtrend. I last wrote about how I expected gold to continue to trade higher if the S&P sold off. The relationship was short lived, once again bringing gold’s safe haven status into question. Funny enough, gold's safe haven bid failed in the 1150-1170 range, which is where it failed when there was the brief and almost forgotten Greece default scare. While this has been a major short covering rally, the gold bulls must have been disappointed when gold stalled in the 1160s as the stock market continued its sell off. Below is the 9 day look at gold.

 

Notice how when gold topped out around 1165 the stock market had yet to put in its low (the purple line is the S&P) and gold progressively worked its way lower. While the bulls had a good run there was serious volume at the 1170 level (sellers defending against a move higher). For now, in the 1120-1135 range, gold sits right in the near the middle of its recent range (1070-1170) over the course of the last 2 months. It is why I think options buyers need to be patient here. As an options buyer you have the control. Being profitable requires the discipline to wait for situations where implied vols get relatively cheap, and you have a strong opinion that movement is imminent..

Why is gold volatility where it is right now? Overtime gold option implied volatility tends to get lower when it trades in the middle of a range. Why was 1 month volatility trading as high as 18% 2 days ago, when equivalent volatility was close to 12% before the drop to 1080? The chart definitely implied a greater chance for a significant move down and quickly at 1142 before 1080 than it does here. While the chances for going lower are still viable and in my slightly biased opinion probable, betting on having it happen quickly is challenging. If you are buying 1 month options and you are right just a month too early, you lose all of your premium. So what to do?

Nothing.

That in fact should be the answer most of the time. Nothing. There is nothing to do, but prepare for the next trade and wait for the opportunity that might arise. Gold’s volatility spike was almost certainly due to the volatility in the stock market. Even while gold stopped negatively correlating with the S&P gold volatility went out. In fact, gold volatility got bid as it moved BACK INTO an area (1110-1120) where it has consolidated before this last leg of the rally. One fairly trustable rule is that volatility will not get bid if the futures are reversing back into a range. That is exactly what happened.  Vol got bid as we came back into the range. When the Vix is trading in the 30s, it is not unreasonable that people who need to own options across markets (for whatever reason) might reach for some gold volatility. Gold volatility has been trading at historically cheap levels, and in a time of panic in stocks, it is not unreasonable for funds with short volatility exposure to buy some gold vol as a hedge. Gold at 16% as it currently, as opposed to the usual 12-13% we have grown used to when heading back toward the middle of a range, is not expensive relative to other asset classes’ volatility. So we are left with a strange situation in which we notice the inter-connectedness of all assets classes, and that gold's implied volatility is relatively cheap compared to others. But should the stock market, and consequently other markets’ volatility settle down a bit (stock up, asset class implied volatility down) gold volatility should come in as well. If gold can move quickly in either direction from here, its volatility may justifiably hold up. But we can only operate on the information we have in front of us. As option buyers, we must realize that the price action of late does not show us a clear reason to believe realized volatility will increase. Implied volatility is also toward the middle-higher end of where it has been on a daily basis for the last year. Higher implied volatility combined with an unclear signal from the price action means we should stay away. With lower volatility and gold closer to either end of the range, options might become very attractive, I actually think that is likely. So while there are a lot of reasons to see the potential for gold to move hard in either direction, exercise patience. While I am sympathetic to the idea that options have been underpriced for a long time in the gold market, I also know how difficult it can be to manage a position when nobody cares to buy options. Death by 1000 paper cuts is still death. So be careful.

I want to reiterate that there are times when options can become very attractive, but that we need to be very diligent if we want to employ buying options as a strategy. Timing, which is a big part of successful option trading, is far harder to nail down than people who do not trade full time might think. Even if you are right over the long term, the smallest difference in timing can be the difference between a loser and a home run. I have seen too often the wrong reaction to this reality of markets. The answer is not that you need to level into positions time and time again. You don’t need to chase the market. You have to be willing to miss what look like incredible opportunities. This market has proven that options can get cheap before big moves. Here, is not the place to put on bets for just that reason. The medium term implied vol is too high right now relative to its mean, and the chart gives us no strong reason to feel strongly one way or the other about direction in the short term. Far too many of the profits I have made on the big moves have been eaten into by my haste to enter trades that are medium term smart, but short term stupid. I don’t want others to make the same mistake.

My hope in writing this article was less to discuss gold than to discuss some of the classic mistakes people make trading options. I make them all of the time, even when I am trading well. As traders we cannot control the speed of the market. As such we must always defend against our urge to put aggressive minded positions without strong cues that it makes sense to do so. Making money is no longer a daily expectation in this patient but prudent trading strategy. It would even be OK to suggest option trading to mom and pop if they understood one simple rule

Never Be Short Options.

If you are a long option/ long spread player you cannot lose more than the amount of money you put in. “Trading” which involves getting short options, is a totally different ball game. That is hard enough as a full time trader, and should not even be considered by a less active player. But for less active players, I would suggest studying some of the historical implied volatilities and weigh them against your expectations for imminent movement. If you can find yourself in a place where the implied volatility is low vs historical implied vol, and you have conviction of a move, then options can be a profitable way to play the game. But you have to be selective. Death by 1000 paper cuts is still death. If you choose to track the market closely, than you will be able to see situations where the risk/reward to play the game is very favorable. If you are not willing to pay close attention, you will slowly bleed buying options in this market.

Be patient, and make sure that if you have a strong directional opinion that the implied volatility is relatively low compared to where it has been. If you see that the implied volatility is extremely low relative to its historical mean, get involved ONLY if you have a real conviction that it might move.

Markets have been a bit finicky lately, and it is easy to get caught up in the hype and feel like you need to participate. This can be a big trap and a more costly one than immediately meets the eye. There are ways to make money in these markets, but the prudent ones will realize that staying flat the majority of the time is the smart move now. Opportunities will arise but we cannot control when they come. If we keep a close eye, we will find opportunities while others are throwing their hands in surrender having painfully paid for options right before things calmed down. Things may go crazy again, but in gold at least, nothing has really changed from a longer term perspective.

My suggestion? Enjoy the last week or so of summer. Don’t sit in front of the screen waiting on the next big thing. Stay flat for the next week and watch how things play out before taking any strong stances. Historically gold sees more activity after Labor Day than in late August. I think there will be some interesting stuff forthcoming in this market, and I will write more if I see anything take place that creates a potential for a good trade. For those updates, please check in at Fiatgold.blogspot.com.

Wishing everyone a good end to summer.

Ben Ryan

Gold rallies over 80 dollars off recent lows (8/21/2015)

It has been a while since my last post, and a lot has changed.

Where we last left off, I had discussed how playing gold from the short side on a short term basis was simply too difficult given the velocity at which upmoves tend to take place compared to down moves. I suggested that longer term players would be better off playing the market from the short side, and that 1150 was a clear place at which to stop out of your shorts. If you sold 1105-1125 as I suggested, you got stopped out for a ~40 handle loss, approximately a 4% loss.

The short gold concept was based around a combination of technicals and the general of a deflationary environment, which has historically been negative for gold. In addition, gold was holding in much better than its precious metal counterparts (silver and platinum) on a historical basis. Given the ferocity of the potential down-move should gold have consistently settled below 1080 made the risk/reward of the downside more appealing.

So now what. And why are we here?

I was recently asked by a reader about how gold would fair in a particular type of economic environment. My answer? I have no idea. Gold’s price is not tied to its utility. Most of the arguments made about what drives gold’s price seem rather incomplete. Why is gold a hedge against inflation? Imagine a hyper inflationary environment. What would you prefer to own? 1 ounce of gold or 400 gallons of gasoline for your car? Most utilitarians would prefer the gas. What are you going to do with that ounce of gold if no one will buy it for you? The gas at least might help you get somewhere. Incidentally, the cost of an ounce of gold and the cost of 400 gallons of gasoline are pretty close right now.

The value of most financial instruments at any given point in time is the price at which it can be bought or sold. In the case of gold, that price has very little to do with what it might do for us on a given day. So let us just accept the fact that fundamental research on gold is kind of a waste of time. It’s price is dictated by perception and money flows.

The Stock market has started to look rather shaky. The money has to go somewhere, and we have begun to see money allocated back into bonds. The general consensus was that bonds could not rally because an interest rate hike was coming. Now people are doubting whether it will happen at all. The Fed, to its own detriment, is being vague in its message. Markets are a bit uncomfortable. China’s recent currency devaluation, questions about the strength of the economy among other things have led to some jitters. We are beginning to see gold have a strong inverse correlation with the stock market. As I write, the S&P has sold off nearly 100 handles in just the last few days. So money is flowing into bonds, and the correlation between gold and the bonds is picking up. So, gold rallies. The stop out point I mentioned from the short trade was 1150, and “prudent longs” all bailed by the Friday afternoon gold settled below 1140. As such,  we should be careful not to take some levels that were significant in the past and assume they will be again. Perhaps 1180 will serve as resistance simply because it has been so significant for so long. But be careful not to assume that gold will behave as it did once before if it reaches the 1180-1220 range.

For now, gold is the anti- stock market. It appears that it has regained some safe haven status. One of the tip offs that gold was in trouble last time we were here (near 1155) was that the Greek turmoil caused the S&P to sell off, but did not cause gold to rally. This time appears different, at least for now. If the S&P were to recover, we might soon refer to this rally in gold as a massive bout of short covering before retesting the new base of 1080. But should equities remain unstable I expect gold to continue to rally. Logically, we can reason that gold is a safe haven against world turmoil. But who really knows. At this point, all we can say is that there has been a strong inverse correlation between gold and the S&P in the short term. This is not the spot to make big bets. Realized volatility has performed well, so if you want to take a stance, owning straddles probably makes more sense than buying or selling futures here. We simply don’t have enough information and need to watch how this plays out before putting significant capital at risk.

If this rally were to have legs there would likely be significant selling coming in around 1230. The level has proven formidable before, and at this point in time, it is where the multi year down trend line comes into play. Please reference past posts to see the charts that illustrate this downtrend.

Now is not the time to be dogmatic. Volatility in these markets remains historically low, so buying options creates a max-loss defined bet that will not force you to exit a trade too soon should the price action be choppy. 

Gold update 8/9/2015

I just wanted to update what has happened since last post, and why I think copper is worth a close look.

Above is the 20 day of copper with gold in purple tracking it. Since gold dropped below copper 3 Sundays ago, you will see gold has traded below copper on this scale for almost the entire time. Now, you are seeing gold hovering above copper. 

There are a few ways one could interpret this action, but my main takeaway is that if this correlation is staying in tact,we will probably expect gold to sell off small or for copper to rally.

On tonight's open Copper gapped down about 1.5 cents.

Copper filled the gap, and now sits right near where it opened. China had a few below expectation economic releases this weekend.

(http://www.bloomberg.com/news/articles/2015-08-08/china-s-exports-drop-as-external-demand-fails-to-offer-relief)

I was curious to see if it might lead to any liquidation in the metals. Copper got knocked down but as mentioned has held up. The question is, is this just a short term rally with a greater trend of selling behind, or was it just one small order at an illiquid time? To be fair, this is not an enormous move (it'd be the equivalent of gold opening down 6-7 dollars on the open). Nonetheless, I want to stress the importance of anyone trading this market on a short term basis to at least keep an eye on copper.

Gold's ability to withstand multiple tests of the 1080 area has created some short term support. As such, there may be some short term traders playing this market from the long side. While I do not have a strong 2-3 day view on gold, I could understand why some short term traders might look to get long between 82-90 area. I would just caution, if you see copper begin to sell off, take note. It might be the signal that allows you to save a lot of money by flattening out should copper lead the way. If copper struggles to stay above tonight's open over the course of the next few days, I would become more cautious as a gold long.

As for the trade I mentioned last time; I had said gold could be sold around 1095 with a target of 1000. I think the trade is the most reasonable out there right now given what I believe to be a very comfortable stop at 1148 lets call it. So, 95 dollar target to the downside with a stopout 53 higher. It's not the greatest risk reward ever, but I think resistance is so strongly defined near 1140 that a breach of this level would clearly mean being short no longer made sense. For someone who has a short bias, I think that is the smart way to play it for now.

If you are more selective in looking for good spots (and that is a good idea, making directional bets in the middle of our newly defined 1080-1104 range is not ideal) then I would look to see if gold can rally first and then sell into it. If for instance you were able to sell some gold around 1105, that trade gets you 105 profit potential vs 43 downside potential. A little bit of patience for a trade that is designed to last a few weeks could do a lot for its risk return profile. While I'd like to see gold whipping around, the price action of late makes it tough to get too strong with opinions in this spot. If gold manages to go below 1080 and sit for a few days between 1070-1180; I think there will be an  an even better risk reward trade from the short side (sell 1075, stop out 1100, target 1000).

As far as trading gold goes, I find that it is better to be a little bit more patient and deal with missing a trade than to worry that you are going to miss the next big move. While I try my best to write about what I see as the determinants of good risk/reward situations, the price action can be very choppy in gold. While there is a longer term downtrend in tact, finding short term trends that allow for definitive entry and exit points has been and continues to be challenging. If you want to be short this market, keep a longer term time frame. Even in bear markets gold makes it hard for shorts with short term outlooks. You are better off scaling in on rallies, or waiting until there is a definitive break of 1080 to pile on. If you are looking from the long side, keep an eye on copper and the dollar. There has been a lot of correlation of late. If either the dollar moves aggressively to the upside or copper moves aggressively to the downside flatten out and wait for a better spot.

I also wanted to let readers know that from time to time my posts will be going up on the Options City blog. My last one can be seen here http://www.optionscity.com/blog/

Have a great week,

Ben

Sunday Night Update (Content included)

I just wanted to update what has happened since last post, and why I think copper is worth a close look.

Above is the 20 day of copper with gold in purple tracking it. Since gold dropped below copper 3 Sundays ago, you see gold trading below copper for most of the three weeks since it happened (based on this scale of comparison). Now, you are seeing gold hovering above copper. 

There are a few ways one could interpret this action, but my conclusion is that if this correlation is staying in tact,we will probably expect gold to sell off small or for copper to rally.

On tonight's open Copper gapped down about 1.5 cents.

Copper filled the gap, and now sits right near where it opened. China had a few below expectation economic releases this weekend.

(http://www.bloomberg.com/news/articles/2015-08-08/china-s-exports-drop-as-external-demand-fails-to-offer-relief)

I was curious to see if it might lead to any liquidation in the metals. Copper got knocked down but as mentioned has held up. The question is, is this just a short term rally with a greater trend of selling behind, or was it just one small order at an illiquid time? To be fair, this is not an enormous move (it'd be the equivalent of gold opening down 6-7 dollars on the open). Nonetheless, I want to stress the importance of anyone trading this market on a short term basis to keep an eye on how one metal reacts. 

Gold's ability to withstand multiple tests of the 1080 area has created some short term support. As such, there may be some short term traders playing this market from the long side. While I do not have a strong 2-3 day view on gold, I could understand why some short term traders might look to get long between 82-90 area. I would just caution, if you see copper begin to sell off, take note. It might be the signal that allows you to save a lot of money by flattening out should copper lead the way. If copper struggles to stay above tonight's open over the course of the next few days, I would become more cautious as a gold long.

As for the trade I mentioned last time; I had said gold could be sold around 1095 with a target of 1000. I think the trade is the most reasonable out there right now given what I believe to be a very comfortable stop at 1148 lets call it. So, 95 dollar target to the downside with a stopout 53 higher. It's not the greatest risk reward ever, but I think resistance is so strongly defined near 1140 that a breach of this level would clearly mean being short no longer made sense. For someone who has a short bias, I think that is the smart way to play it for now.

If you are more selective in looking for good spots (and that is a good idea, making directional bets in the middle of our newly defined 1080-1104 range is not ideal) then I would look to see if gold can rally first and then sell into it. If for instance you were able to sell some gold around 1105, that trade gets you 105 profit potential vs 43 downside potential. A little bit of patience for a trade that is designed to last a few weeks could do a lot for its risk return profile. While I'd like to see gold whipping around, the price action of late makes it tough to get too strong with opinions in this spot. If gold manages to go below 1080 and sit for a few days between 1070-1180; I think there will be an  an even better risk reward trade from the short side (sell 1075, stop out 1100, target 1000).

As far as trading gold goes, I find that it is better to be a little bit more patient and deal with missing a trade than to worry that you are going to miss the next big move. While I try my best to write about what I see as the determinants of good risk/reward situations, the price action can be very choppy in gold. While there is a longer term downtrend in tact, finding short term trends that allow for definitive entry and exit points has been and continues to be challenging. If you want to be short this market, keep a longer term time frame. Even in bear markets gold makes it hard for shorts with short term outlooks. You are better off scaling in on rallies, or waiting until there is a definitive break of 1080 to pile on. If you are looking from the long side, keep an eye on copper and the dollar. There has been a lot of correlation of late. If either the dollar moves aggressively to the upside or copper moves aggressively to the downside flatten out and wait for a better spot.

I also wanted to let readers know that from time to time my posts will be going up on the Options City blog. My last one can be seen here http://www.optionscity.com/blog/

Have a great week,

Ben

FOMC Minutes Released, Bears still in control of Gold 7/29/2015

Another FOMC minutes release has passed. There was the usual media excitement leading up to it, and the usual muted response from the market that follows. People get very riled up when talking about interest rates and the implications of raising them. I turned off the TV this morning when I realized that the segment was being dedicated to speculating on whether today's minutes would include adjectives used in previous minutes releases. Apparently economists are going to have to get PHDs in linguistics if the Fed stays heavily involved in markets much longer.

Let's do a quick reality check. What does the labor market have to do with interest rates? 

Most would say something along the lines of "low interest rates are important at times of economic slowness because it makes borrowing cheaper. In turn, people are more likely to start businesses, take out a mortgage, or hire new employee". I think that comes at least somewhat close to capturing the general perception of how raising interest rates changes the economy.

If you are someone who thinks this way, I would encourage you to consider the idea that the labor market has very little to do with this, and that a 25 basis point raise would have almost zero effect on an individual's decision to take on a mortgage or start a business. Neither would a 1% raise in the cost of borrowing.

Someone who is considering taking out their first mortgage is not concerned with 25 basis points nearly as much as they are their own sense of security about their future cash flows. Imagine a couple with a combined annual post tax income of $100k shopping for their first home. How big is the difference between a mortgage that requires $25k in annual payments and 30k?

One payment is 25% whereas the other is 30% of annual income. Is 25% clearly a reasonable amount to spend? Is 30% too much?

You can't answer the question until you know more about this couple. If you learned that both members of the couple were high school teachers in a well to do town, the mortgage at 30% might be very reasonable. If only one member of the couple works, and he happens to be an options trader, 25% is probably too much risk.

In this example, 5% is a minor consideration among the other risk factors that will ultimately guide this couple's decision. 25 Basis Points is only 5% of 5%. It is a rounding error when it comes to real people making real financial decisions.

So don't buy into all this rate hike hype. We all need to be a little smarter than to take the Civics 101 explanation that the Fed minutes provide. 25 basis points is statistically insignificant to the vast majority of individual or small businesses considering taking on a loan. The question then becomes, if "labor market slack" really isn't what is at stake with this potential rate hike, what is?

Derivatives with price sensitivity to interest rates.

While 25 basis points means little to me, it might mean the difference in millions to companies who have outstanding floating rate debt. If companies take on debt with exposure to rising rates (particularly leveraged exposure), small raises in rates could be their death knell. The derivatives market is enormous. Trillions of dollars enormous. While the gold options I trade every day are cleared on an exchange, a great number of outstanding derivatives are private deals between companies (banks, insurance companies etc). Following the economic collapse in 2008, our entire system of commerce was thrown into panic. Stabilizing the banks, and probably more importantly, their ability to meet their obligations to their creditors became paramount. When leverage gets involved, small differences in interest rates can turn into economic landmines. We cannot know for sure what  motivates Fed policy, but there are a few simple things I would suggest we all keep in mind.

1)Derivatives were at the heart of the Financial Crisis of ~2008

2) Derivatives' (options, futures, private contracts) value can be highly sensitive to interest rates

3) Federal Reserve (along with the Treasury) market intervention has increased drastically since the beginning of the financial crisis

4) The Federal Reserve sets the discount rate, which effects all interest rates, and therefore, the price of derivatives.

I am no economist, but I have traded every FOMC minutes release for the last two years, and I can say first hand that over time markets have begun to care progressively less about them. The options action in gold really tells the story best.

It used to be that hype would surround a Fed meeting, and options would get bought and volatility would firm in the days leading up to the event. If nothing happened, the options would get crushed following the minutes/meeting, and life would go back to normal. The perfectly executed strategy would involve buying options in the days leading up to the event, and selling them all and getting short right before the release. It worked for months.

Some people realized this pattern of excitement manifested in options buying was exploitable. As more Fed meetings passed, the sellers started selling earlier and earlier. Those who started buying days in advance were buying into an onslaught of volatility selling....I was one of those people at least once. At a certain point, it became clear that there was a paradigm shift.

What was once the meaningful event that brought fear and options buying to the market, has become a time for traders to sell options. In many ways it makes sense. Nothing has really changed except the warning the rate rise is happening by the end of the year. And the fact is, we've been told that. Does it make a difference if its next month or the month after? The only way it would fundamentally make a big difference is if the derivatives out there could somehow blow up as a result of the rate raise and cause calamity. 

We might not all know about the loan exposure of a firm that is essential to our economy's stability, but Janet Yellen does. There has been ample time (about 7 years) to let some of these contracts expire, and figure out to do with the other ones. Remember, the government bought a lot of these derivatives itself. The Fed knows what they are doing, and if they are going to start raising rates, that means it is probably safe to. 

There will be no drastic economic slow downs due to a few 25 basis point bumps in the discount rate. If a lot of money moves in markets and the liquidity is not there to take the other side of orders, there could be some chaos. But the Fed has telegraphed their intentions so clearly that anyone with major blowout risk from a rate rise has had plenty of time to hedge appropriately.

As for gold, while it has made multi-year lows since breaking support at 1142, it has held its own. With managed money now net short gold, we are seeing gold hold up pretty well given the new short interest in the market. Since gold's 50 dollar dive two Sundays ago (low 1080) gold has only managed to push 8 dollars lower, and that was met with strong buying. The trend is unquestionably down, and nothing has taken place that negates that. With open interest building from the short side, short covering rallies are always a possibility. However, resistance has been strong near 1104. In fact, while gold has spent little time as low as 1080 (the Sunday low) it has not been able to test the recovery high it made off that low that same night (see picture below).

This is a 20 day chart with each candle representing one hour of time. Notice how the move down to 1080 happened in a flash. That same night it rallied all the way back to 1118, but it has since failed to retest that high (or even get close). You can see in the chart above how I drew a horizontal line around 1086. This seems to be a pivot point for the short term chart. I see the bears as maintaining control for now because while there has been some short term support at 1086, it has been unable to hold a rally of any consequence. If it were to rally above 1110, I think you would see some short covering and a likely retest of 1130, and possibly quickly. If you are short gamma, be careful not to get caught if we trade above 1104 as I don't see much to stop it from an extended rally if it gets above 1110. All that being said, this is just not a good risk reward here to get long. If you want to play this market from the long side, I think you want to be buying when you see the buying come in, not trying to get in front of it. For people who haven't traded gold before, if you are impatient, don't put anything on at all. Gold often makes you wait longer than you ever thought humanly possible.

On a longer term outlook.....

Above is the 3 year chart. Notice the big down channel I've drawn. The tops connect remarkably well. The bottoms look good, but right here we sit on a decision point. While it briefly broke the line two times, it has not settled below it on a weekly basis. The more gold sits here and consolidates, the more bearish it will become. If you look at the previous 3 points on the down channel you will notice that they all saw strong rallies off the lows back up to the top of the channel. If you see gold consolidate here, it will be a sign that the strong buying presence at this level has evaporated. If a longer term downtrend like this were to break it could lead to a drop of hundreds of dollars rather quickly. However,  there are multiple banks out there with targets of $1000 (over different time periods), and that alone makes me think there would be some medium term support at the millennium mark. If gold were to rally and put in yet another bottom at this level, 1130-1145 would serve as major resistance. A rally above ~1145 could produce a retest of the May high near 1235 (that is approximately where the top of the channel would come in if the rally took place in the next few weeks). If you want to play the market with an outlook of a couple of months, you could get short here around 1095 looking for 1000 and stopping out at 1140; While it is probably a positive expectation bet in this spot, I personally will be watching the price action into at least the middle of next week before taking any strong directional stance.

-Ben Ryan