Trading volatility with Gold

Fundamentals of Gold

Gold was down almost $40 on Friday, Nov 2.  It got to resistance of 1730 a couple of times and broke down to <1680 .=".">

Many speculators started to bail out and questioned the long term bull run. Many gold bugs blamed it on manipulation but corn, wheat, oil and all commodities were also down. To me, the key reason was the strengthenening of the US dollars most probably because of increased uncertainty in Europe.

Short term, I cannot predict the direction but long term the trend is clear. It is continuing on a bullish run.

Gold can be very volatile but the fundamentals remain intact. The fundamentals are firmly in place and perhaps getting stronger.

Countries worldwide have accelerated the printing of currency to maintain competitiveness. It is basically a currency war, which devalues its intrinsic values. Bernanke has his $40 billing monthly mortgage purchase and another $45 B operational twist totally $85 b of liquidity pumped monthly into the market. US will continue its QE into next year no matter who is elected on November 6^th. It is QE to infinity.  There is no way out. The process will continue and probability is the Fed will increase the money printing with hurricane Sandy last weekend. Quantitative Easing is now a permanent fixture of the financial markets for, without it, the U.S. bond market would collapse and interest rates would reset multiples higher. Gold remains a sound “yet to be recognized “ monetary asset.

China pumped a record $60 b into the country’s money market last week. The previous record was set only in September just a week before the weeklong national holiday. Japan central bank said it will offer unlimited loans at low interest rates to lenders to try to boost credit demand among companies and households. China and other creditors nation continue to accumulate gold and silver to protect the potential devaluation of the US dollars. Most of them are buying on the dips.

As of Oct 31st, the Bank of Japan increased the QE program to $138 billion US or 11 T yen. The cumulative size of the the stimulus so far is now $825B.

In a few years, we had QE 1,QE2, QE to infinity, cash for clunkers, Tarp, LTRO, OMT Home buyer credit, New job program and operational twist. Yet, Europe is still on the brink of crisis and the only way out is to continue to print money to ease the liquidity and save the  impending collapse of Greece and Spain. France is on a huge liberal monetary expansion reducing retirement age, increase basic wages, benefits without the financial base to support it except to print more money.

With the impending fiscal cliff and imminent breach of the debt ceiling, US credit rating could be downgraded.

Trading range

Gold is still trading at a range between 1500 and 1800. for almost a year now.

Trading is never easy. The market can be irrational longer than you can expect.

Let me do some recalls on the dot.com and housing bubble.

Dot.com Bubble : Valuation was outrageous. I kept shorting stocks and was stopped out many times.

Finally, I decided just to allocate a sum of money and short the highest valued stock in the technical sector. I sufferred tremendous emotion anguish with the huge volatility. I remembered that the names I shorted included high flying stocks like Yahoo, EMC, CISCO, etc.Finally, when the whole thing burst, it was the most profitable year I ever had in my 20 years of trading experience. I had more than 80% ROI. They were stocks that I shorted that went to zero. I was also scared out of Worldcom and Nortel which would had given me huge profits as these stocks went to zero. The market has a way to get you on the wrong track if your conviction and research are not strong enough.

Housing Bubble: Going back to the housing bubble, same thing happened. I saw the bubble at least 2 years before it burst A few of my trading pals discussed and marvelled how it defied gravity and continue to go up even we know it was totally wrong in the fundamental directions. All kind of explanation were given for the rise like “this time it is different”;  “ house value can only go up”; “it is a new paradigm” etc. 

I shorted stock like KBH. I was stopped out a couple of times. Eventually I did make some money on shorting KB Home but did not have the conviction to hold through all the volatility. I got out way too early.

Taking a recent example, I shorted Groupon. Personally, I have done quite a bit of ground research on the company based on their marketing practices, financials and business models. Something is terribly wrong with the company. So I shorted it. But it went against me a couple of times. But I held firm although I had a stop loss which was not triggered despite a couple of short covering that almost flushed my stops. Now I am in the right direction. I will hold it until my fundamental views are proven wrong

Now lets move to gold and silver.

It is similar to the dot.com bust and housing bubble except it is in the reverse direction. The fundamentals are fully in place and getting stronger.

But gold was whacked by $40 on Friday! It can still move down to $1600 or $1500  and still stays within the range. Worst, it can even go to  $1350   although  I doubt it will happen. But in these volatile market, anything can happen.  The only sure conclusion is the final direction will be up and it may even breaks 2000 within 6-8 months. Longer term, it is going much higher.

The market has a way to create such fear that all the longs are flushed out before it starts an incredible rally. It has a way to do whatever it takes to upset most investors. Thus, things will go up when majority is out. So far, they are still some support bullish speculators holding to it. When these speculators gave up, it is a clear sign it has bottomed. From the COT ( commitment of traders report ), it has not happened. Likewise, the housing market went to an unbelievable top before it crashes. Is this “buying when there is fear and selling when there is euphoria or greed”?

Path Forward?

I suggest two strategies.

1. First, work on a longer time frame. Hold a small core position and let it run. Take it as an insurance on your  total portfolio. Be prepared to be take >50% haircut. This is what I am doing with my 5% allocation physical gold and silver holding. Just leave it at the vault and do not sell until we are in a mania or euphoria, which will come eventually. So far, these investments have done very well. I bought gold at around $700 and silver at below $15 about 4 years ago. I wish I could have bought more.

2. As long as the market does not violate the longer time frame, the bull is on. Having said that, gold mining stocks dived down on 2008 breaking every longer term trend lines in 2008 before it formed a double bottom and then charged forward with multiple baggers in 2009. If you have the guts to hold on, you will still make lots of money in 2009. It was one of my best years but I too sufferred some psychological damage at the end of 2008 and got out of some stocks which eventually went up 5-6X.

 

To trade:

           

-        I maintain a bullish bias.

-        When the daily trend (regression channel + MACD are my favourite indicators), I went long.  I stay on a daily and weekly time frame to gage the trend.

-        When momentum is starting, I remove all hedges and went naked.

-        Upon a possible top, I will add my OTM Short calls. If I am wrong, I will be called out on my stock making some good money. At the same time, I will continue to add bull puts or naked puts or even stocks when the trend is continuing. Thus I continue to maintain my positions even though my previous positions were called out. One key advantage of this strategy is that you take some profits and wait for the next trend to return.For example, I have made my money on RGLD and is waiting for a right time to get back again.

-        When the daily starts to turn down, I will add short term ATM puts. This change the covered call position into a collar. Instead of using stops, I will be out of my position when the put expired. If the stocks bottomed and rise, I will lose some money on the puts but this is taken as fees for insurance. The overall position is still very profitable.

-        Sometimes, I spend a little more time managing the puts. As long as the trend is down, do not take out the puts. If it continues to go down, buy a new put ATM and take profit on the original put when it is close to expiration. When trend is stabilizing, sell a SP to convert the long put into put vertical. This will help to pay for the long put. But do not add the SP until the trend has turned up on the daily chart.

-        As long as the trend is down, I will continue to wait for a reversal. Do not get in ahead of time. Trust the trend and your indicators. There will be certainly some mistakes along the way but it will be cushioned by the time and volatility premium gained during the trade. The tendency is to bottom feed because of the bullish bias and it can hurt. It is never late to wait for the trend to turn bullish and jump into the wagon

Currently, I am collared before the smack down on Friday. I will be out of all my positions taking profits I made over the last month or I may move the current put down to keep my position. I am tempted to short but it is dangerous because of the fundamentals. So I refrained and just made money from my slightly bearish collar. If gold fails support at 1650 this week, then I will be stepping aside as it may move down all the way to 1500s again. This is a difficult position given the bullish bias fundamentally but you have to trade what the charts tell you until it aligns with the fundamentals eventually.

Once the trend is reversed I will be back to the game again. Actually, the current downturn is a surprise to me as I expect the QE to infinity should drive price up. But similar patterns happened in QE2 where price initially went up and then down to below the price when it was announced. But subsequently, it shot up 90% from the level at the date of announcement. I am still expecting similar pattern for QE3. The pattern is not confirmed until price actions staged a clear reversal.

It is frustrating but I think this is one good way of handling the volatility. It has been going on for more than a year.  Once the trend returns, I want to make sure I will be there. Perhaps, it will return only after everyone has given up. In that case, the profits will be much better than trading volatility with bull puts, bear calls etc. Currently, the short term trend is down. I want to see some good support at 1650 before making any further adjustments. If there is no strengths at the rebound to 1700, I will be adding more OTM short calls.

The best money is made when it catches the trend correctly. But do it with risk control, care and knowing the market can go against the fundamentals for a long period of time. It can be frustrating but with patience, you will be proven right.

As to the timing, I am not sure when this Keynesian Economic experiment will end but it will certainly end one day badly. My gut feel is that it is getting very near to the cliff. Short term there will be ups and downs but the end game is near.