Gold still Golden for Put Sellers

It’s the commodity with which non-commodity investors are most familiar. It’s probably the most “emotionally” driven commodity where core supply demand factors matter little.  And no matter what price it’s at, somebody always loves it.

It’s Gold. And no matter what your investment experience, I’d be willing to bet that you’ve at least considered buying some for yourself at some point over the past 18 months. Many others thought that way too. Prices have continued to climb higher as a result.

All the way up, analysts have been split: Will it go to $2,000? Will it go to $200? I’ve heard arguments for both sides.

The reality of it is, it will probably go to neither.  The nature of gold invites extremism. The public appetite for gold analysis allows the extremists to get on TV and publish newsletters. This drives the public to gold investments. This is not to say that buying or selling gold is a bad investment in and of itself. However, the aspect of this that interests us is this: The amped up rhetoric makes people buy gold options – Deep out of the money gold options.

Gold Overpriced?

The recent correction in gold prompted a reappearance of the bears arguing that gold is “overpriced” and headed for a steep correction.

I wouldn’t bet on it.

While the recent weakness may have rattled bullish day traders, gold is big picture market. And big pictures are slow to change. Gold has effectively been in a bull market since year 2001 when the US dollar began it’s multi-year decline.  While that may have been the initial engine driving the gold bull, it is a different set of fundamentals that took over the latter day bull market.

Those fundamentals not only remain in place today, they appear to be getting stronger. This is exactly why we believe that while limited corrections are a certainty, the longer term trend towards steady to higher gold prices should remain intact for awhile.

3 Key Supporters for Gold Prices

Gold analysis always runs the risk of oversimplification. It’s a complex commodity that sometimes doubles as a currency. There are dozens of factors that can combine in hundreds of ways to push the market in different directions on a daily basis. Again, however, we are focused on the big picture. As option sellers, we can afford this luxury.  And the big picture is this:

  1. Gold Prices tend to do well when interest rates are low.  Rates remain at historic lows and will most likely continue to stay there through at least early 2011.
  2. The US federal deficit continues to swell like underwater Gulf Oil plumes.  Despite the short term strength in the dollar, the massive debt will be a threat to the stability of the US currency for the foreseeable future. A weakening dollar has historically driven inflation spooked investors into gold.
  3. The general undercurrent of uneasiness that continues to underpin all asset markets from stocks to real estate. Everyone wants to believe the recession is over. Then we get housing and manufacturing numbers. Everyone wants to believe equity prices are going to return to “normal.” Then we have a “fat finger” day.  Add uncontrolled federal spending (see item #2), a Euro debt crisis and lingering fears of conflict with Iran and/or North Korea and you have a deep pool of investors taking comfort in investing in something physical. Something that will have value if everything else goes away. Something they can hold in their hand.

Again, these are big picture, slightly vague, longer term reasons that should support gold. But those are usually the kind of things that pull the market in certain directions over the longer term.

Gold prices could drop $100 an ounce tomorrow.  I doubt they will, but they could. Short term price moves can happen any time for a number of reasons. In our opinion, however,  the factors mentioned above should make it difficult for gold prices to enter into any sustained period of weakness over the next 3-6 months at least.

That’s why selling deep out of the money gold puts on weakness like this week’s seems to make so much sense. You’re not going to hit the highs or the lows on the head. But get the long term direction right (or at least don’t get it too wrong), and you can do very well selling options.

We don’t see gold prices dropping below $1,000 an ounce in the near future. As a (put) option seller, that’s all the analysis you need to do. In this case, you profit as long as gold prices do not collapse.

If that’s not anti-extremism, I don’t know what is.

By: James Cordier, Michael Gross

James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodities options. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC.  Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009) is available at bookstores and online retailers now.

** Price Chart Courtesy of CQG, Inc.

***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.