Gold has been trading in a range for a while now, but it looks like it is time for this beast to awaken. We have several catalysts coming into play; both fundamental and technical that could turn gold into a good trade.
There are two questions on everyone's mind right now: What is going to happen with the fiscal cliff; and what is going to happen to Greece? The main concern is how politicians plan on handling the fiscal cliff. Basically, they need to decide how they are going to handle the mass spending cuts and increase in taxes that are going to happen in the new year. I think it is pretty obvious that they are not just going to sit back and do nothing and let the United States enter a deep recession. That we do know. What we don't know is exactly what they plan to do.
Gold has always been considered the safe haven. That is because gold is a commodity and a scarce one at that. Gold carries a negative correlation with stocks, bonds and other commodities. Investors will use gold as a way to protect against inflation, devaluation of the U.S. dollar, and decline in stock prices. The Fed will be speaking this week (11/26 - 11/30) and as the fiscal cliff talks draw on, traders will look to gold to stem of the decline in stock prices and protect against the uncertainty the U.S. government will deliver.
Along with the Fed talking we also have talks about Greece. International lenders will be meeting to strike a deal and see if Greece will receive its next payout. These talks will try to decide what Greece's debt target should be. They have tried these talks last week and were unable to reach an agreement. These failed talks have already helped push gold higher as we saw last Friday. Now they are going to try again. If they cannot reach an agreement, there will be trouble getting Greece their next payout of 44 billion euros.
Not only does the uncertainty of the U.S. and European governments make gold a good trade but we are seeing things line up technically too.
One way we watch gold is through its ETF (exchange-traded fund) (GLD). On Friday GLD quietly took back the 50 day moving average. It was a solid breakout over the 168.40 range and the 50 day moving average. The series of higher-highs and higher-lows formed in GLD tells me that this uptrend is not over. By making its last low down off the 200 day moving average, this ETF looks prime for taking out new highs.
So not only do we have a fundamental reason to get into this trade but now a technical reason. Now we just don't want to rush out and get long GLD shares because there is another trade setting up.
Taking a look at volatility, we notice that it is at all time lows. With volatility running so low, it is making options incredibly cheap. The December at-the-money (ATM) straddle is only pricing a $4.60 move in GLD. That is approximately a 2.7% move by December expiration. If you ask me, that is cheap. Last time volatility was this cheap in GLD, we bought a straddle that paid off nicely for us. You can read about that play HERE. Now volatility is even cheaper and the setup is looking better.
We are not interested in getting long puts because we are bullish on GLD right now. We want to enter long calls or a bull call spread. We are going to avoid the bull call spreads because this is a exhibits a "breakout" skew. Basically that means that out-of-the-money (OTM) puts and calls are both expensive relative to the ATM price.
The "U-shape" in the skew tells me that I don't want to sell the calls in the bull call spread. That would mean I am selling a higher volatility than I am buying, and having the short volatility go up would not be ideal to our trade. We are actually interested in just getting long calls.
So the million-dollar question. What is the trade?
Long GLD January 171 Calls for 2.77
The GLD January calls will allow us to take advantage of the increase in volatility and the increase in price. We chose to go out to January because December only has 27 days left. Calls in December would get hit with heavy time decay. We also went for a slightly OTM call at 171. Right now the 170s are getting bid up which is making them a bit more expensive than we would like.
The target for this trade is to be out by December expiration (12/21/12 - The end of the world). I have a price target of $173 and expect volatility to rise at least 5% to get back in line with normal. If we can meet both of those conditions by December expiration we will be looking at a ~64% profit on investment. We will take any profit that delivers a 50% gain or $138 for a 1 lot. Since that is our profit target, we are not willing to take a loss greater than 50% of our investment or $138 for a 1 lot.