Golden Opportunity with Defined and Limited Risk

Despite the continuing US dollar strength, gold turned higher on Friday with Comex cash gold breaking out above 778.16. Since gold is currently oversold this move could be just short covering, but it could also be the start of something more.

Here are some considerations.

• This is a noteworthy breakout from a consolidation pattern formed by the October 22nd low for gold.
• Physical demand has been reported very strong perhaps reflecting a loss of confidence in the banking system.
• The long-term seasonal price pattern usually reaches its peak in late December.
• Hedge fund liquidations and tax loss selling may soon be ending.

This is an uncertain market environment and gold may be worth considering once again in the event this recent breakout proves to be more than just short covering.

Here is a bull call spread suggestion for a long position in the gold ETF with defined and limited risk: SPDR Gold Shares (GLD) (78.85). The Trust holds gold and issues shares in exchange for deposits of gold.

With large trading volume and open interest the bid/ ask spreads in the options are reasonable. The current Historical Volatility of the ETF is 45.

• Buy GLD Jan 80 call GLDAB 5.75 IV 49.60 Delta .5159
• Sell GLD Jan 85 call GLDAG 4.05 IV 51.13 Delta -.3992

Debit 1.70 Position net delta .1167

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Since the time decay is almost entirely offset for this spread, the debit Monday for the spread should be about the same price if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .12 for each point change in the stock price.

Set the SU (stop/unwind) at a close below 70. If the rally loses momentum the implied volatility will likely rise as the stock turns lower. With a 5% absolute rise in implied volatility the risk at 70 would be about $95 or 56%. The gain is limited to the difference between strike prices less the debit of $170 or $330 for a one-lot position representing 100 shares of the ETF. The entire position risk is the total debit of $170 but by setting the stop at 70 we can limit the loss to around $95 (presuming we have correctly estimated the rise in implied volatility) while having a potential a maximum gain of $330 if the gold ETF continues higher and moves back up to the previous resistance at 90.

Disclosure: no positions