Why I'm Betting on a Surging Gold Price

Sep. 4.07 | About: SPDR Gold (GLD)

When it comes to gold bullion and gold stocks, I need to confess that I started my investment career in 1984 as none other than a mining analyst. Ever since those days of calculating net present values on my trusted HP12C I have been intrigued by the shenanigans of the yellow metal, and related stocks.

And, over the years I have also learned that one should never underestimate the ability of the gold price to surprise when least expected. Friday’s jump of $8 is a case in point. I argued the virtues of a position in gold bullion and gold stocks in an August 14 article entitled “Gold – more than a safe-haven play,” and was therefore not particularly surprised to see some glitter returning to the gold market. However, what did surprise me was a fascinating research study on the outlook for gold bullion that has just landed on my desk. More about that in a moment.

First, let's set the scene by focusing on a chart of the gold price. A few observations come to mind when analyzing the movement:

  • The price graph is again firmly above both the 50- and 200-day moving averages.
  • The MACD oscillator has just given a buy signal.
  • Gold stocks (as represented by the AMEX Gold Bugs (HUI) Index) has started outperforming the gold price – always a positive sign for gold bullion itself.
  • Source: StockCharts.com

    The research study I refer to was done by Adrian Douglas (www.marketforceanalysis.com), and deals with an analysis of the open interest of Comex gold options. Douglas’s track record on this front is excellent as in November 2005, he predicted when the gold price was less than $460, that a mega-move was afoot. He based his forecast on a very large build-up of call options in the underlying stocks of the HUI Index. This turned out to be spot on as gold subsequently surged to $714 by May 2006.

    This is where it becomes very interesting. Similar to 2005, Douglas has now again noticed a massive build-up of call options in the October and December Comex gold contracts.

    Figure 1 below shows the cumulative open interest across all strike prices for gold call and put positions for October. The blue line indicates that if the gold price should increase to, say, $850, approximately 40,000 call options would be in the money. The red line, on the other hand, illustrates that if gold were to drop to $625, about 20,000 put options would be in the money.

    FIGURE 1: CUMULATIVE OPEN INTEREST OF PUT & CALL OPTIONS - OCT 2007

    Source: Adrian Douglas

    Interestingly, the blue line (calls) flattens at around 42,000 contracts, whereas the red line (puts) flattens at 26,000 contracts. This indicates that there are 1.6 times as many bets that gold will rise rather than fall.

    Where the curves are not flat, two distinct slopes can be identified as shown by the two different dotted lines labeled 1, and 2. The blue dotted line (1) is very steep, indicating that speculators are prepared to bet heavily on the gold price increasing to at least $740. The second slope (2) is much lower, indicating that speculators are less keen to bet on gold rising above $740 by October.

    On the red curve the dotted line, (1) indicates a willingness by the bears to bet on gold declining to around $625, but the second sloping line (2), indicates there is much less enthusiasm to bet on gold falling much below that. The bulls betting on a gold price of $740 outnumber the bears betting on a price of $625 by almost 2 to 1.

    Figure 2 shows similar information to the previous graph, but for December 2007. Notice that the total open interest for the calls across all strike prices is 122,000 contracts – almost three times the level of October! The total put option open interest has also risen to 63,000 contracts, which is 2.5 times the October level. The bets by bulls outnumber those by the bears by 2 to 1.

    FIGURE 2: CUMULATIVE OPEN INTEREST OF PUT & CALL OPTIONS - DEC 2007

    Source: Adrian Douglas

    There are again two dotted lines in red. The red dotted line (1) is a higher slope than the red line (2), suggesting bears are not enthusiastic about betting gold will fall below $600.

    Now look at the blue dotted line (1). There is only one slope! This suggests speculators are not backing away from betting on gold rising even above $1,100 by December. The open interest in play on the call side is a staggering 12 million ounces. Put differently, this is almost 25% of the worldwide annual mining output. While many options are settled in cash there is always the possibility of a significant proportion being exercised for futures contracts or gold bullion.

    Douglas said:

    I consider option players highly sophisticated speculators. The sheer size of the call position and the eagerness to speculate with equal propensity for small rises in the gold price as for very large ones are truly astonishing and should, just as in 2005, be taken very seriously.

    It is probably no coincidence that the build-up of the Comex positions also corresponds to a typically strong seasonal period for gold. I believe one can do a lot worse in these rather testing times than follow the smart money being positioned for a strong rise in the gold price.