Gold can't get a safe haven bid

I left off saying that 1205 was a critical level for gold. It turned out to be the high.

I have found most people who watch gold asking themselves the same question lately. How can this thing not rally in the wake of all that's going on in Greece? The S&P gapped down 40 handles on Sunday night.  Gold rallied about 15 bucks, failed, and closed back near unchanged by day's end.. Given the slow grind up we have grown used to with the stock market, a 40 handle gap is a big deal. If news could derail the S&P like that, there should be safety bids across the board..... but gold failed.

As I write, we trade near 1173, right about where we settled last Friday. The situation in Greece has only gotten worse since then, yet gold remains decisively unchanged.

Technically, gold continues to look shaky at best, but it has simply found ways to rally in too many technical doomsday scenarios (looking like it would collapse but it rallied). But there is an important take away here even if you don't want to get involved in placing directional bets.

Gold is FINALLY starting to gain a public persona. As gold has swung back and forth in ranges that are old and boring, the public has completely lost interest. At the same time, you have seen a stock market up 200+% in just over 7 years, so its no surprise gold has not been hot on people's radar's.

So what is gold's public persona?

That it is not a safe haven. If the Greece situation becomes tricky and leads to more serious political"brinksmanship" maybe it'll generate some buying interest, but thus far, evidence points to the idea that gold is not considered a "safe haven". 

In effect, as I have said in times past, gold has been going through a massive identity crisis. When QE (quantitative easing) began in the U.S. gold had a very clear identity. It was the thing you bought when people became fearful of inflation due to the increased money floating around. I was clerking at the time, but I watched people make a lot of money riding that wave.... and guess what.... the whole idea was wrong.

All the QE, zero interest rates, and whatever other "accomodative" policy we have seen over the last few years, has not lead to inflation. In fact (take it for what it's worth) policy makers would rather see more inflation in our economy, as the "below target rate" inflation we are seeing can be viewed as a sign that money is not making its way through the economy quickly enough. In other words, there is a lot of money out there, but it isn't creating a vibrant economy that leads to demand and in turn, causes the prices of goods to go up. But, all the people who believed that QE would lead to inflation, and bought gold on its rip to 1900, still made money, even if they were completely wrong about how quantitative easing would effect inflation.

Gold is something people buy and sell. It's price is more a matter of psychology than anything else. Demand for gold was fueled in the QE inspired bull run because of a fear of something. A general understanding existed among market participants that if you were afraid of inflation, this is where your money belonged. It was an idea, nothing more or less, but it was enough to create an identity that could create an investor base with a reason for interest.

THIS GREEK THING WAS A BIG DEAL FOR GOLD.

It has at least established one part of gold's identity. It's not the thing you buy when an EU country might default on their debt obligation. It might seem like a sad and slow step, but it is something. Over time, as gold goes up or down in accordance with these perceptions among investors, trends will form. When trends form, trading starts, and that is what leads to a vibrant market. It's a small start, but I am being sincere when I say that I think this Greek situation has been a big deal. If gold had rallied to 1200 like it has so many times, we might still be hearing about "the safe haven bid". But it didn't, and I believe that the investment community, the same community that could've cared less about gold for the last 2 years, has had no choice but to take note of this pathetic performance. It is hard to begin the process of finding one's identity by being picked last in the pick up game, but at least its an opportunity to build some character.

These are some interesting times and I don't mean to be hard on gold when I refer to its broken identity.... I think there are other markets going through similar things. It is important to tread lightly while trading all of these markets right now. There are simply too many things at play that are outside of our capacity to understand that can destroy a good thesis (massive central bank intervention). There should be (and in gold options finally has been for the last few days) some 2 way trading, but building a position is tricky as the market can flip on a dime (for reasons we don't, and probably won't understand).

If you don't want to be bored with my chart ideas, stop reading now. Remember, the Employment report was pushed to Thursday because of the shortened week.

Above is the 90 day chart of gold. I only want to point out 2 things.

1) Gold is entering a decision point. The uptrend line drawn from the low of 1141.6 has seen multiple tests of late.The line has managed to hold, but it is getting tested more frequently, and the bounces are less pronounced.... which is not a very strong sign for the metal.

2) There is a profound similarity between the pattern we are seeing now, and the rally to from 1170 (right here) to 1232 and its sell off following the high. Notice how there is an uptrend line that held from ~ 1145 in late February, which formed its second point around 1170 in late April. Following this test there was strong buying that lead to the rally all the way up to 1232.

After it failed 1232,it worked its way back down to the trendline in late may around 1185, and it consolidated in a very tight range along that trend line for nearly 2 weeks before breaking, and forming the 2nd bottom of the new uptrend line.

I see the same thing repeating with this new trend line. Instead of rallying to 1232, this rally failed at 1205. Now gold is testing this trend line more often, which as mentioned in point 1, is signaling that buyers are struggling to regain control.

I don't think gold stays here for too long. Phones have been buying back straddles (bought back options they have sold, indicating option shorts might be concerned of a pending move). It is also this meeting of trendlines, a decision point where we see whether the buyers or sellers have more pull.

I would be surprised to see gold consolidate here for more than a few days. Thursday's employment number might be the catalyst for movement. If it is to break upward I think it will run into resistance and struggle to break above 1192. It is harder for me to guess where a sell off might land gold. Certainly the chart above's low of ~1140 would be in play, but it would have the potential to go much lower. A drop to 1140 would only be the 3rd test of this area (low 1130.4 in November and the 1141.6 you see in March) since 2010. If a new low were to be made, barring any miraculous bouts of buying (ala the rip post the first test of 1130 which found us near 1200 within about a day) there isn't much support until at least 1100.

Low Volatility and It's impact on options markets

The front month gold straddle expiring next Thursday can be bought for about 14 dollars. That means you breakeven if it moves 14 dollars in either direction at any point over the next 4 days.

We often hear about “low volatility environments” and how it is bad for markets. But what does that really mean? I am referring to implied volatility, ie the prices of the options. I am telling you that in % terms they are as low as I can remember (not just the short dated) in at least a year. But I think it is important to consider the example of the July at the money straddle above. Looking at the gold chart, you can see that over the course of 4 days we often get 14+ dollar moves, sometimes you get a few, and that makes owning this straddle a very smart buy based on recent history, but still, it gets sold.

Naturally as vol sits on yearly lows, one can say that staying short vol has been a good strategy, but that’s not necessarily true. And here is why.

The person who buys the July straddle at 14 dollars has a maximum loss of 14 dollars. The person who sells it has potentially far greater losses. If the July straddle settles 30 dollars higher or lower, the seller has lost 16 dollars. They lose more than the max loss of buying it on a 30 dollar move. On a 50 Dollar move they lose 36 (lose 50, but took 14 dollar credit). So who would sell it?

We are sitting at 1200, again (yawn, 1200 has become my least favorite number). Gold loves to settle around here. The interpretation that the fed was dovish in its statement helped gold rally over 30 bucks over the course of 2 days, and here we are again. At a place of consolidation, it is natural to see heavy vol selling. While the straddle intuitively seems very cheap at 14 dollars, the seller has reasons to sell.

If you were to create (at expiration of the straddle) a breakeven and likelihood scenario it would look like this.

Seller of 14 dollar straddle makes 14 dollars at 1200. Every dollar it moves away from 1200 by expiration next Thursday afternoon, he loses. So if we settle 1202 he makes 12 dollars (14-2), if it settle 1197 he makes 11 dollars (14-3), if it settles 1100 he loses 86 dollars (14-100). If we could weigh the likelihoods of all of these scenarios, we could figure out what the fair price is.

The reason someone can justify and probably expect to be long term profitable selling this straddle is that we are sitting at 1200. There has been so much consolidation around this number, and so many settlements very close by, that settling right about here is a high likelihood. Therefore, the straddle seller can ascribe a high probability to settlements where he collects nearly the entire amount of premium (the whole 14 dollars if we settle 1200)… 13 if we settle 1201 etc. Based on the amount of movement we see in this market, Selling a 14 dollar seems risky, but the reward is pretty good.

Hopefully this whole example hasn’t been too confusing for those not familiar with options. But I wanted to go through it to try to illustrate what happens as volatility gets lower and lower.

Are you a buyer or a seller of this straddle? You must consider that the amount of capital you have behind you and can afford to lose is probably more important than your actual answer. As a seller, you have the capacity to take losses much bigger than your potential gains. Therefore you need to be very well capitalized. So that the time it does move $100, you will still have the capital to come back and start selling again.

Think about the rift this creates within the market. It essentially takes away the ability of smaller, less capitalized participants to trade from the short side without risking exponential downside. The advent of computerized trading has made “edge” more limited in liquid markets. That “edge” (mispricing of options that allowed traders to buy one option and sell another against it profitably with limited risk) was crucial for smaller players who could make up for the days where the 14 dollar 4 day straddle might not be a buy.

Here is the key thing to remember. The more volatility comes in, the less sellers are getting compensated for their risk. Selling a straddle outright gives you unlimited downside.  There are phones (funds banks etc) that sell straddles and walk away. They are well capitalized enough that they can afford to put up the margin to finance the risk, and absorb the losses should a move happen. Smaller players simply CANNOT trade this way because of the small buffer between collecting small profits and blowout risk. Smaller capitalized firms, locals, and independent traders have to consider that they have limited amounts of capital, and that one swift move, and their career is over.

This asymmetry that results, in which lower capitalized players are really only able to play the market from one side, should be a red flag to market enthusiasts. A healthy market is a market where price discovery is a result of buyers and sellers trading against each other. This market (and liquid options markets at large) are suffering because the players in the market have stood on very different grounds as volatility has continued to come in. What is the result of this? Locals lose money. Gold settles 1200, and the local who bought the 14 dollar straddle just lost 14 dollars. Without the afore mentioned edge trading to finance the losses of buying these cheap straddles locals slowly start to bleed money. The way to stop the bleeding without risking all your capital little is simply to stop trading. And that is precisely what has happened. Smaller participants have left, which only reinforces consolidation of trading into a few big groups, or what I would call an unhealthy market.

I believe that the first rate hike is what is necessary to bring any semblance of volatility back to these markets. When there is more volatility, you will see traders re-entering the market because volatility creates opportunities that are not always so binary in nature (like the straddle being a buy or a sale). My hope is not that a small discount rate raise will cause havoc, but that the money flows that would likely take place as a result lead to some good trading and encourages traders to get back into the market.

For Gold, this 1205 level is pretty critical. A fail here would re-inforce golds downward bias, while a break higher should set up a test of the 1225-30 area, and a break of that should lead to a retest of the 1260 area.  

Potentially a lot of opportunity.... but be careful of strong directional bets

Normally by 9 on a Friday I'd be doing just about anything to think about something other than the gold market. But, tonight, I am listening to the music I listened to senior year in college, which reminds me of the question I asked myself before graduating college. "Why am I not rich with all this free time on my hands and such a great number of bad poker players out there?"

Seven years later, I am wondering similar things. Part of me will always be upset that my good friend Sean (who continues to be one of the best heads up online poker players in the world) and I didn't walk away from college as millionaire 22 year olds. We didn't.... but we could've.... Why didn't we?

Because we weren't willing to see the bigger picture in front of us. Poker, a pretty mathematical game on the lower skill level games, could've been exploited with just a little bit of work. At the time, I would've told you, we can't beat it..... and given you any number of excuses. I'm not mad at young Ben. But I realize that at the time, I over estimated the others out there.

Enough with the memories.... what does this have to do with gold?

Stop Over Estimating the people trading this market. There may be a ton of opportunity here. Gold continues to search for it's definition. Since gold has been confined to this range over the last 3 years (mainly between 1400 and 1130) it is easy to get lulled to sleep. But this is how cycles work. Periods of extended boring nothingness tend to be followed by  more violent moves. Tracking shorter term trends in gold, you will notice that there are periods of extended slowness followed by quick pops and drops.

Above is a look at gold on the daily over the last 3 years. It has Essentially been creating smaller and smaller ranges. Notice how over time, specifically the last 6-8 months gold has done almost nothing. Many decide to look elsewhere. I think gold is 2-10 months away from being a very volatile commodity. I would say this is the quiet before the storm. So, the lack of interest in gold makes it all the more interesting. As a trader of the gold options market, I can tell you first hand there are not many participants in this market right now. When it actually moves for once (which it will) interest in the metal will re-emerge. As traders enter the market, people start trading more, and the market starts to be a real market.... but for now, its slow.

It's slow because speculators have realized that this commodity has had to consolidate for a while, and they will re-enter when the time is right. I believe that time is sooner than some might think, but funds know in a market like gold, it is better to wait until the break and then get on board than try to call the trend too early. The chart above should make that point pretty clearly.

As far as the short term chart goes, gold looks nothing short of terrible

I spoke in previous posts about how to maintain the uptrend, gold would need to settle at or above 1195 by June 15th. There has been very limited interest in rallying the metal. When solid volume sell orders come in, there are few buy orders coming in to fight back. What has been shocking to me is how slowly the sell off has been. I've said that I expected gold to trade down to 1140-1150 as soon as it broke 1175. Today, following a strong NFP, it is clear that I was wrong.... it didn't sell off so quickly.... but it didn't rally either. Options action would tell you people are not really betting on the downside, but options action hasn't been such a great indicator of direction on any medium-long term basis. So, gold doesn't move much, but the price action tells me we will either rip higher towards the broken trendline (1192) or slowly grind to 1150 and then we can re-evaluate.

The crazy thing from an options trading perspective is that implied volatility is about as low as its been over the last year. If gold were to go and retest 1130 (the low in the last few years) a break should technically lead to another 50-75 lower. In what looks like the middle of an established downtrend (assuming the lower line I've drawn is actually valid) gold should retest  1140-1150 in the next week or so, but it all seems to be happening very slowly.

For those looking to get involved in trading the precious metals, keep the following in mind.

1) Interest rates effect this stuff in ways that might not be obvious to us. Some people put trades on because it is so easy to leverage them.... if they are unable to get to same leverage in a higher interest rate environment, it could take a player out of the market.

2) The options buying in Comex Gold has all been in 2016. The differential in volatility (expectation of movement over the long term vs short term) between longer dated and shorter dated options has moved out in ways that has not been seen in a very long time in this market. SIMPLY PUT: People are paying to see movement after new years 2016 but not before.... so this may continue to be a choppy range.

3) Look for a reason to believe in a short or long that is more than technical. If you are good enough to trade direction in this market profitably (without working 24/7 and making a small return) let me know, because you are better than I am. 

But the metal lacks an identity right now. Is it the dollar that matters? Is it rates? Is it a strong/weak stock market? I will give my opinions on these things in later posts.... but for now, no one's opinion matters. Gold is not a good long or short from a retail investor's perspective. It simply has some more work and soul searching to do. It may find its way soon, or the chop fest may continue. I promise to write about it if I see a sea change beginning.... but for now its quiet. 

I'd be biased to the downside in the short term... but my best advice would be to stay away from putting on any directional bets through outrights. Options are cheap enough to make some defined-risk (pre determined max loss) bets on the metal.... but I would avoid buying/selling any purely directional products (futures/ etfs etc).

Conclusion: Don't let the low volatility make you forget that we are still near the low end of a multi year down trend. That being said, directional bets are far less EV (expected value) than bets on volatility over the next week or so. My concern is that gold could get stuck because there are no major economic releases Mon, Tue, Wed, Next week... and gold has not moved on non-eco news days lately.

Enough for now. Please comment if I have poorly explained anything and you want to give me a second shot.

-Ben