A Bullish Gold Trade That Is Highly Likely To Work Over The Long Term (If It Does Not Work Over The Short Term)

Includes: DUST, GDX, GLD
by: Southwest Michigan Trader

So, far I have posted three articles on SeekingAlpha, these have been involving long trades in stocks I found to be very favorable longer term risk reward propositions [2 articles on Genie (NYSE:GNE) and 1 article on Ambarella (NASDAQ:AMBA)]. Through feedback - folks have asked me for more frequent trade ideas. So here's a gold related trade that if it does not work this week will turn into a position I would hold for the intermediate term. That sounds like a loser's bet - never let a trade turn into and investment they say. Well, let me explain this one and why I would actually be willing to enter the trade knowing if it does not work this week that holding medium term I am still pretty likely to be a winner. NOTE: This trade should only be taken in very small size which I will explain later.

The trade involves shorting DUST (Direxion Daily Gold Miners Bear 3X ETF).

First, what is DUST? DUST is the 3x leveraged bearish gold miners ETF. DUST seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the NYSE Arca Gold Miners Index. As many folks know these 3x levered daily funds are structurally flawed longer term. Here is a good explanation from an earlier article of why these ETFs are mathematically flawed ("google" leverage ETFs and you will find more explanation on these ETFs). However, the basic point in shorting the levered ETFs is unless a trend stays in place literally forever, these ETFs will head toward zero over the long term. Even if the market just chops up and down but trends up you will be a winner by shorting these 3x bear ETFs due to the structural flaws in the way they are designed. Now, the providers of the 3x ETFs do disclose these things won't work long term, for example Direxion says, "This leveraged ETF seeks a return that is -300% the return of its benchmark index for a single day. The fund should not be expected to provide three times the return of the benchmark's cumulative return for periods greater than a day." Still, many retail investors get lured in by the 3x leverage and do not understand holding this long term effectively guarantees them to be a loser. The way I look at these levered ETFs, especially the 3x bear ETFs, as the short investor in these trades you are the casino/house and the long investor is the individual player/gambler. Meaning, the odds are easily in the favor of the "house" over the long term, even if the player occasionally gets on a "hot streak".

So, why take this trade now? Well, everyone knows gold (NYSEARCA:GLD) and gold miners (NYSEARCA:GDX) have been destroyed lately with gold down around 20% in the last few weeks and the gold miners stocks down about 30% in that same time frame. This has led the DUST ETF to almost double in weeks. I personally do not expect gold stocks to go to zero and a near term a bounce seems likely, however, people are now in margin call mode so the dump can be much greater than one would imagine.

So, today I sold DUST short at $98. If you can't locate shares to short you could sell call options or buy puts as options are available here.

The reason I am shorting this versus just buying GDX is the reasons I mentioned earlier about how over the long term these levered ETFs are flawed and I do not think gold stocks are going to zero. Additionally, due to the flaws in the levered ETF structure even if gold stocks go up and down and up and down that choppy activity will cause my position to slowly become a winner.

The risk in this trade is that gold and gold stocks just continue a straight line down over the near term and this ETF just moon shoots even higher (which is possible). This would result in significant losses to my position on a percentage basis over the short term (this could move against you 30-50%+ if gold just crashes further). How do I defend against this - through trading a very small position size initially here so I can hold on if this position goes against me early (because over the long term due to my "house" advantage I believe I will win in the end). I can not stress taking a very small size position here enough as this is a falling knife situation. This is the type of trade I will take to try to add a couple points of performance to my account over time. The great thing about selling levered ETFs is if you catch the short trade near tops it becomes mathematically very difficult for these ETFs to ever reach these peaks again.

I plan to update my trade in the comments section as it goes along.

Disclosure: I am short DUST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.