Still Bullish on Gold but Options Traders Should Take Profits Now

Gold has appreciated the past two days despite the equity bounce.
By Ben Cross ,

Editors' pick: Originally published June 29.

There are plenty of reasons to remain bullish about the price of gold, but investors who followed our advice to adopt an options trade on gold may want to take their profits now and wait for another attractive opportunity to invest in the precious metal. 

Just to review, that trade involved buying one call option with a $1,350 strike price for $21 and selling two call options with a $1,400 strike price at $10.50. This trade initially had a zero premium, so your upfront cost is zero, with a maximum profit of $50 if gold futures hit $1,400 an ounce. (These trades use options on gold futures at the Comex.)

We can see that gold futures gained back the small losses they incurred Tuesday and made additional gains. The August futures, upon which our trade is based, are up $9 to $1,327, and the $1,350 calls, which were the heaviest-traded option Wednesday morning, are trading at $16.50, while the $1,400 calls are trading at $6.20. That's means the 1X2 strategy we recommended implementing for zero premium is now worth $4.

Because this is our first trade, we would recommend taking the profit. We are still bullish on gold, but the implied volatility has come in very quickly, which is why this trade has benefitted.

On Monday the "wingy" lottery ticket gold calls were carrying a substantial implied volatility premium of close to 3% over at-the-money calls as the Friday-Monday action going into the options expiration on Monday was huge. Now that gold has had a two-day consolidation, the implied volatility differential has narrowed to 1.5% and the at-the-money implied volatility has come down from 20.5% to 17.5%.

We still expect gold to grind higher, but we like building a war chest to employ when we spy another advantageous entry point. It is never good to be greedy and always good to be lucky.  

Our worry is not the direction of gold but our view that investors are being very complacent about the global fixed-income and currency markets. The CBOE Volatility IndexI:VIX  which is a bellwether measure of market fear, is being sold with impunity, suggesting that we could be in for another scary reversal.

In addition, as we approach the end of the month and the end of the quarter, we do not know what flows or redemptions are in place, but it's likely that most gold longs have inflows. Obviously, gold is getting a bit of a geopolitical bid on back of the horrific attack in Istanbul, but such moves never last long.

More importantly is the worry over the Italian banks as Prime Minister Matteo Renzi battles with German Chancellor Angela Merkel on how to shore up those lenders. The knock-on effect to Deutsche Bank, which is now trading at a larger discount to tangible book than it did at the height of the financial crisis, and Credit Suisse, which is hovering around all-time lows, is going to keep confidence stressed and help hard assets like gold.

The last but possibly most important thing to watch is the strength of the yen and the continued pressure on Japanese government bond yields, with the 40-year now at .065%.

All this currency and interest rate turmoil is helping Asian investment in precious metals. The People's Bank of China and Singapore's sovereign wealth fund, the GIC, which usually trade ranges in gold, are now not active sellers, so with only producers there to offset fresh investor demand via exchange-traded funds and futures, we may see another spike to fill Friday's gap to $1,362 an ounce.

Speaking of the PBOC, it seems that it may have been intervening to support the offshore yuan Wednesday, which rallied 0.26% against the dollar overnight. The U.K. represented 13% of China's trade with the EU last year, and the weakness in the euro and pound in the wake of the Brexit vote could cause a slowdown in Chinese exports, which could delay the Chinese economic recovery. This could threaten the already questionable 6.5%-to-7% growth expectation for China, which will also cause people to want some portfolio protection like gold.

Futures volume in gold has been a relatively paltry 14 million ounces, but one reason is that it has given way to an enormous spike in the volume of the higher-beta precious metal: silver.

Silver, which has been a sideshow this year even though it has outperformed gold, is up 3.5% on volume of more than 360 million ounces. The average silver futures volume is closer to 100 million ounces by this time of day. The interesting thing is that silver ETF outflows last week were very heavy (300 tons) leading into Brexit while this week has seen fresh inflows. Surprisingly, there has been very little option volume in silver with some interest in December $20 calls with an expiry of Nov. 22, which are trading at 80 cents per ounce, or implied volatility of 29%. One would suspect that silver producers will be looking to add some hedges at these levels, especially those from south of the border, but let's not forget that silver traded as high as $51 an ounce in April 2011. At that time the gold-silver ratio was around 30 while today it sits at 73, so we will look more closely at silver options going forward.

In other commodities, oil continues its path up to $50 on a larger-than-expected draw of inventories of 4.05 million barrels. This was slightly higher than yesterday"s API draw and more than the 2.5 million barrels we were expecting. What is going a bit under the radar is that the main reason for the drop is the 10% week-on-week fall of imports.

Gasoline inventories continue to rise on lower demand.

Natural gas futures climbed to a 13-month high of just under $3 before falling back. The forecasts of warmer weather persisting throughout the West and Midwest and increased electricity usage nationally should benefit natural gas.  We are looking at implied volatilities that are pretty much a straight line at 38%, but a NGQ6 (July 27 expiration) 3.00/3.25 call spread may be worth a short. It can be purchased for 4 cents.

Copper continues to consolidate around the 200-day moving average, and the producers are getting the added benefit of the move in the byproduct of silver. Copper warehouse stocks at the London Metals Exchange rose, but Shanghai Futures Exchange speculators continue to get long on hopes of a cut to China's reserve requirement ratios (a central tool of China's monetary policy). China's official Purchasing Managers' Index is due for release on Friday, and will be an important piece of economic data.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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