Let us start with the U.S. dollar, which had a really bad week after Bernanke and with the Fed`s dovish stance towards inflation. The dollar is now near a three-year low at 73.11. Much of the dollar weakness can be attributed to Bernanke's style rather than substance, with his statement that there will be no QE3 due to the upside benefits being outweighed by the negative side effects of creating additional inflation in the economy. That is actually something new out of Bernanke, and completely missed by the market.
Last week the bulls were in control, and they were going to take advantage of some earnings momentum and light volume trading to push assets across the board to new highs. However, there were many who have already priced in the potential for QE3 to come in and support asset prices during the summer doldrums, and we now know that isn`t going to happen.
In short, everything negative is being priced into the dollar, and everything positive is being priced into risk assets. This will reverse course over the next couple of months, as markets are forward looking. It is highly doubtful that everyone will just wait till the official end to QE2 and start rebalancing portfolios starting July 1. By the way, July 1st comes on a Friday, which also coincides with the BLS release of the Employment Report reading for the June period.
The standard operating procedure is to front run any event, but especially something as crucial as the ending of a liquidity program that inflated assets across the board by upwards of 35%. So market players will start rebalancing, shorthand for selling and taking profits in risk assets at various times over the next two months.
So, how will this affect the U.S. dollar?
The majority of the dollar`s weakness can be attributed to traders shorting the U.S. dollar and going long commodities and risk assets (The actual stated goal of the Fed QE2 Initiative). Well, this trade will subsequently reverse those two trends and serve to support the dollar. Add in new traders piggybacking on the reversal of fund flows, and the U.S. dollar starts to gain some momentum, forcing additional short squeezes. We ought to have a nice little summer rally for the dollar.
Yes, the dollar may still have some room to the downside over the next couple of months, but it isn't much, maybe to the 70 level at worst. But the flip side is that it has much more upside potential over the next six months, at least to the 80 level over the next six months.
So, the trade on the dollar is to start scaling into a dollar long position over the next couple of weeks. Take an initial position in something like the PowerShares DB U.S. Dollar Index Bullish (UUP) under $20.90 a share, and start averaging into a long position in 100 share increments. A 500 share commitment will run a trader around $10,450 at the price of $20.90 a share. This isn't the preferred way to take advantage of the dollar trade, but it is a legitimate ETF, and it does track the basic moves in the U.S. dollar.
The ideal way to play this reversal would be to buy market data for DX contract, itself traded on either the NYBOT or the ICE exchanges. You get more bang for your buck as it captures the full move in the U.S. dollar. The levels would be to start buying on dips to the 73 level, and averaging into the trade in increments if it happens to go lower from 73 to the 70 level, space it out, with stops below the 70 level. If the Dollar Index breaks 69.80, there is something bigger going on such as a currency crisis, and the trade setup is invalidated.
If we start heading higher and putting in higher highs, I would average up into this trade as well. So buy part of the position at 73, and a second sum at 74, and a third at 75 on the Index with a profit taking goal sometime over the next six months at around the 80 level.
You should move up your stops as the trade become profitable to lock in your profits, just leave enough room so you do not get taken out on short-term retracements. This is the one trade where averaging down and up into the position makes sense to the point of the 70 area stop. Because one cannot exactly pick the bottom, and the risk/reward upside potential makes the trade positive expected value from a numbers standpoint.
The Gold Trade
Gold has had quite a run over the last month, and actually a nice four months in 2011 after an initial profit-taking mode. Gold was around 1,300 in late January, and has since risen to the 1560 level as of Friday April 29.
In market terminology, gold is overbought and due for a correction. If you put up a chart of the U.S. dollar, it is the inverse of gold for the most part. If the dollar reverses course, expect the same for gold. But the general sense is that gold has come a little too far too fast, and is due for a correction sometime over the summer months with the ending of QE2 stimulus.
There are a couple of ways to play the gold correction. One is through the futures contract. Frankly, if you were able to put a short on Friday at just a tick under 1570, this should be a good trade for just even a short-term pullback in the metal. I would place a stop at 1571, and look for at least a $20 to $30 pullback for a pretty good risk reward trade.
But from a longer term perspective, Gold should retrace a lot more than $30 over the next six months. With a reversal in the dollar, there really isn't major support until the 1,300 an ounce level. So, how does an investor play this longer term correction in the gold market?
One way is to short the SPDR Gold Shares (GLD) instrument at around the $153 level if you can with a stop at $154. Look to ride this correction down, carefully moving up your stop to lock in profits along the way. I would re-evaluate the market conditions around the $130 level to judge whether to stay with the trade or take profits at that point.
Another way to trade the GLD would be to average into the trade, but this is only for the most experienced investor. Under certain scenarios, gold could blow through 1600, and you have to be able to tell the difference between a stop run spike and enduring momentum where you don't want to be short.
This can only be gauged at the time based upon market conditions, but I might average into a GLD short in 100 share increments starting at the $153 level, adding a second 100 shares at $155, and a third with 300 shares at the $160 level, for a total of 500 shares exposure. If GLD starts to break hard above $162 with strength, then I close out the trade and re-evaluate for another short entry. Not all trades work, you look for a positive risk/reward setup, and establish the trade with controlled risk.
Another way to trade this would be to wait for the upside momentum to be confirmed, and start adding on the downtrend. But like anything, there are tradeoffs involved with this strategy as you are going to give up at least $14 dollars per share in profit in the GLD just to begin to get a downward confirmation signal. And it varies among traders on what constitutes confirmation of a downtrend. For example, some traders wouldn't enter on the short side until a break of the $135 or $130 level. It is just personal preferences in regards to each investor`s risk tolerance levels that they feel comfortable with.
Finally, another way to play the correction would be to buy some GLD puts on a day when they are bleeding red all over the screen, i.e., when nobody thinks they will ever be worth peanuts. For example, you could buy the July 130 puts for roughly 33 cents per option contract. These are pretty decently valued, it allows an investor to have a fixed risk profile, i.e., 100 options could have a fixed max loss of around $3,300, excluding commissions which with most brokerages is an additional $200 to open and close out.
I actually prefer this method best because the GLD puts are so cheap right now. I wouldn't hold through to expiration, I would wait for a nice three day sell-off in gold, evaluate whether it is gaining momentum. If not, you can close out the puts for a nice trading profit. You do not have to pick that exact strike; pick a level where you feel comfortable with, this is just to serve as a starting point for your own research on the matter. Different strikes have different advantages for the investor, but you get the gist of the options trading strategy on a gold correction over the next 6 months.
The Silver Trade
Now we get to my favorite trading instrument, the silver market. The market where MF Global thought they needed higher margin requirements than the CME. That tells you all you need to know about the silver market, it is volatile as heck.
Needless to say, if the U.S. dollar and gold have a correction sometime this summer, you can bet silver will correct, but by a factor of at least five more in the direction of the correction. This makes it from a risk reward perspective seem very attractive when searching for trading setups.
I wouldn`t suggest trading the futures market in silver, for example. It was down 11% in one 24 hour period, and back up another 11% in the next 24 hour trading period. But we can utilize the iShares Silver Trust ETF (SLV) for taking advantage of an upcoming correction. There are two main ways to put on this trade, one with shares of the ETF, and the other with options on the ETF.
Let's start with the ETF shares, ideally one would hope that speculators in the futures market would push silver to $54 -$56 an ounce over the next couple of weeks for one last push, and then you would enter a short at whatever level coincided with that in the SLV ETF. But silver closed Friday, April 29 in a relatively weak fashion, so you might never get that ideal short entry level.
One method would be to wait for the next major push in silver, and enter a short there at near the top of that push, with a stop just above that recent high established before your entry. This method ensures very little loss (stop gets hit). And if you're right and silver starts putting in lower highs, just keep moving your stop safely down to lock in profits.
Some key levels for profit targets for SLV would be the following: There isn't even minor support once SLV starts on the down trend until the $35 level, with the next and more meaningful support level at $30. If SLV breaks $25 with force, then look out below. Major forced liquidations could occur, sending this vehicle down to the $18 area.
An investor will constantly have to re-evaluate the trade to decipher market conditions, and adjust risk and profit goals accordingly. Remember, there is a different risk reward profile as your trade becomes even more profitable. But the ironic part of markets is that the lower silver goes, the more attractive it becomes to shorts, causing it to go down further. The exact opposite scenario of the upside move in the metal.
Now, let us examine the options method of trading SLV. Again, you want to wait till the SLV puts are bleeding red on the screen before acquiring the puts. A couple of conceivable candidates for puts would be the July, 15th 2011 30 and 35 strikes; they can be purchased for 26 and 60 cents per contract respectively.
However, I would wait for another push up in silver to try and get these at a better price, as the 35 strike gained 12 cents alone just on a closing basis from the previous day. You have to really pay particular attention to price with options to avoid giving too much of your profits away to the market makers in the field.
The same comments I mentioned regarding GLD options apply here to SLV options in allowing for a fixed risk profile, various strike tradeoffs, and trade management strategy.
It is inevitable that there will be a sizable and significant correction in these three markets over the next six months, given the ending of the QE2 initiative in June and no imminent QE3 Initiative on the horizon. Besides the absence of monthly QE2 liquidity infusions that have helped inflate risk assets like gold and silver, (and served to deflate the dollar and make it even further utilized as a carry provider) trading philosophy will change back to normal.
No longer will traders come in and buy the dips on weakness, but will revert back to the historical patterns of last summer, where they sold into market weakness which caused a substantial correction in risk assets.
I have no real doubts about there being a meaningful correction in these markets, and so the goal is to strategically position oneself to maximize profits for this event. The trick will be in getting the timing of these trade setups right, so as to capture the bulk of the correction. This will require constant monitoring of market conditions to decide how best to apply this trade setup in the correction of the “Risk On” trade.
You may miss the exact top or bottom of the move, have to employ trial and error, but stay focused on the overall goal of catching the bulk of the corrective move, and your portfolio will reap the rewards of being ahead of the curve, and not just one of the lumbering herd of bag holding investors in these markets this summer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.