By Benjamin Lee
In the current market, would you be content with a one year, 50% return on investment? That is precisely the question that investors in gold are going to have to ask, and ultimately answer for themselves.
Early Tuesday morning, gold futures (/GC) hit an all time high of $1923.70 on heavy volume, as worries in Europe continued to take their toll on world markets. The move translates into a 55% jump in gold prices from this time last year.
The jubilation for gold investors quickly soured, however, as the commodity was immediately sold off, once again moving below $1900. The previous high of $1917.90, which was recently set on August 23rd, was also quickly sold into, leading to a vicious 11% move to the downside (to $1705.40) in just three days.
It appears as though a similar scenario is currently unfolding, as bulls could not manage to hold the $1900 level yet again – this time forming a bearish double top pattern in the process.
What is especially troubling for investors is the decoupling of gold's relationship with the overall market in today's action.
The formula over the past year has been simple – market selloff = gold surge. That trade has broken down today, as all major U.S. indices are currently down over 1%, while gold futures are virtually unchanged.
Divergences such as the one noted above often serve as clear warning signs that a trade is about to undergo a massive correction.
Put it this way, if panic and market selloffs no longer support inflated gold prices, then what will?
The meteoric rise in gold prices over the past year has been justified by the need for a “safe haven” for investors during times of uncertainty and market turmoil. If that sentiment dissipates, then gold will plunge, as there is no longer a catalyst to support such a high valuation.
In addition, there are rumors on the floor of the CME that additional margin rate increases for gold futures are imminent. Traders are worried that the rate increases will have a negative effect on gold prices, the same way they contributed to silver's plunge earlier this year.
Betting against gold has been a losing proposition for quite some time, however all good things must come to an end. The inability to hold the $1900 level for the second time may serve as the catalyst that finally sends gold prices back down to earth.
Time will tell.
Investors who believe that gold still has room to the upside might want to consider the following trades:
- Manage your risk. There is no doubt that gold has rewarded investors will great returns, however, no one ever went broke taking a profit. Taking a bit off of the table at current levels to lock in gains is a prudent idea. Should gold break above $1920 again, that would be a great time to reenter, as a push to $2000 would appear likely.
Investors who believe that today's action is a precursor to a large downside move in gold prices may consider these alternate positions:
- At such high levels, the risk has transferred squarely to the bulls. Getting short a large position here with a minimum target price of $1704 ($1600 looks likely) and a stop out above the all time high of $1923.70 provides for a fantastic risk/reward ratio.
- If you prefer ETF's, check out the SPDR Gold Trust (NYSEARCA:GLD). Selling 180 to 185 strike calls for a nice premium is a good way to pad your account with some extra cash, while still leaving some room for error.
- If you want to be really aggressive, pick up some out of the money calls – somewhere around the 160 strike, which would equate to roughly a 10% downside move.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.