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There was a time when the mainstream investment community would collectively roll their eyes when somebody on television started rambling on about what a “great” investment gold would be. With a “here we go again” look on his face, a mainstream analyst would patiently listen and then point out all the reasons why gold was a poor investment. For the better part of 20 years, the mainstream analysts were correct. For while the 1990s were enjoying the tech stock boom and the early 2000s experienced both real estate and equities bull markets, gold prices continued to flounder, plodding along uneventfully. Gold bulls continued to point to economic indicators, inflation and various “doomsday scenarios” as reasons to buy gold. Few listened.

Today, the Gold Bugs have their revenge. It is 2008 and commodities markets are on a tear. Equity and real estate prices are plunging. The US dollar is collapsing under the weight of a spiraling federal deficit and relentless rate cuts by the US Fed in an effort to head off an impending recession in the US economy. Inflation is rearing its head again. Prices are rising in everything from gasoline to steel to corn to plastic. In this parabolic price advance of many raw materials, gold has led the way higher. As of today, Gold prices are at their highest levels in the history of the Gold futures contract.

A gold bug’s revenge indeed.

If you were wise enough to begin stockpiling gold bullion, stocks or futures in 2002, or even if you didn’t join the party until lately, chances are your investment has produced some handsome returns. But what about the rest of us?  The $64,000 question these days is, “Is it too late to buy gold?”

We would like to provide an answer. However, in order to do so, we would first like to rephrase the question as “Is it too late to participate in gold’s bull market?”

Here at Liberty Trading, we believe the answer to be “no.” As long as one uses a strategy that allows for volatility and periodic corrections, we feel there remains a wealth of opportunity in gold. However, before describing a strategy, it may help to examine the reasons why the bull market in gold is not over and why investors should still want to participate.

I have to admit that we are recent converts to the gold bull club. I was one of the people that listened patiently over the years as the occasional gold bug would call up and feverishly outline his case for buying the precious metal. Some of the arguments seemed downright absurd, and on several occasions I pictured the person calling from a bomb shelter filled with canned food, a rifle and a lock box filled with gold coins.

While the reasons for gold’s meteoric rise may not be entirely congruent with the arguments of yesteryear’s gold bugs, they are well ingrained in the market and will probably stay for some time. By most practical standards, this unprecedented bull market began in 2001-2002 and coincided with a number of geopolitical events. China’s entry into the WTO happened in 2001. Nobody knew then how dramatically this would affect the world economy. We do now. 9/11 rattled world financial markets and changed the political and financial landscape forever (in addition to adding fuel to many a gold bug’s “Armageddon” scenario). Fear was now a player in many an investors mind and while investors did not necessarily flock to gold, it began a trend towards holding gold in many mainstream investment portfolios.

While these factors may have laid the foundation for a long-term bull market, they have little to do with gold’s most recent advance – which could be described as nothing less than spectacular. From July 2007 through this week, gold prices have increased by over 50%. The old fundamentals of this market, South African mining data, Indian jewelry demand, miniscule changes in international central bank policies are out the window, at least for the time being. Gold is being traded almost like a currency and the engines driving the bull originate here in the US.

While the macroeconomic factors driving gold are numerous, it is safe to say that a perfect storm of economic occurrences have combined to create the current bull. At the risk of oversimplifying, the three main drivers of escalating gold prices are highlighted below.

1. – Declining housing prices, the subprime meltdown and the resulting credit crunch have shaken the US economy and have pushed the US to the brink of recession. In an effort to spur the economy, the Fed has relentlessly cut US interest rates since last summer (not coincidentally, the same time that gold began its recent advance.)  These series of rate cuts along with spiraling US budget and trade deficits have substantially undermined the value of the US dollar. A falling dollar means that it takes more dollars to purchase the commodities priced in dollars – a main reason for the commodity bull market as a whole. However, another word for “commodity bull market” is inflation. As the dollar falls, the value of commodities priced in dollars rises – to one degree or another. As gold’s value is most closely linked to the dollar, it has seen the most dramatic appreciation – correlating very closely to the dollar’s decline.
2. Flight to Quality Buying – Gold has traditionally been an investment for times of economic uncertainty and 2008 would certainly qualify as one of those times. With both real estate and equity prices experiencing substantial declines, investors have flocked to gold funds and ETFs along with coins and bullion. Buying comes from both fear of the unknown and a desire for profit. Gold has also experienced an extra wave of buying from investors looking to hedge against inflation. Thus, it is not industrial or commercial demand for physical gold that is driving price. It is investors wishing to hold gold for pure appreciation that is driving demand. As with any commodity, as demand increases, so does price.
3. US Debt Holders – Dollars for Gold - Foreign governments currently hold about 1.3 trillion dollars in US public debt. This is dollar denominated debt. Thus, as the value of the dollar falls, the value of their “investment” falls. In an effort to hedge against declines in the US currency, many governments are now plowing their US dollars (at least temporarily) into gold, driving demand even further. In other words, they are holding dollars, which are declining, which they can trade for gold, which is increasing. Buying gold could be an all around good play for foreigners holding dollars who wish to cash it in later for more dollars. Consider that gold, as priced in dollars, has increased by 113% over the last five years. But priced in another currency, such as the British Pound for instance, it has only appreciated by 70%.

While these factors may explain why gold prices have increased, investors want to know if prices will continue to increase and, if so, how to profit from such an increase.

Our opinion is that gold should continue to be an excellent investment for long-term investors. With US housing and equities probably needing to get worse before they get better, the Fed’s not-so-subtle insinuations of further rate cuts and an increasingly nervous investor public, the dollar should continue to devalue and gold should continue to be an attractive asset for investors looking for safety and appreciation. All of the factors that have driven gold prices for the last 5 years remain in place and look as though they will continue to play out for the foreseeable future.

Timing, however, is everything. No bull market moves in a straight line and in a market that has risen as quickly as gold, corrections can be extreme. Buying at the wrong time, especially for futures traders, can be hazardous to one’s financial health. One way around this, however, is to sell puts.

When the trader sells options – in this case, puts – exact timing becomes less of a factor in a successful trade. One of the many benefits of writing option premium is that a far-out-of-the-money option will accrue losses much more slowly than an actual futures contract in an adverse move. Thus, a seller of puts can be in a much more stable position to ride out a correction than that of a futures trader simply buying the gold contract. The example below explains the concept.

Example

A trader is bullish gold but wary of short term corrections. Rather than buy gold futures, the trader elects to sell an August Gold 720 put option(s). He collects a $410 cash premium for selling (or writing) the option. He puts up approximately $1100 of his own money as a deposit (in futures options this is called margin) to hold this option. Now gold prices can move up, down or stay the same. As long as the price of gold is anywhere above $720 per ounce at expiration, the option will expire worthless and the seller will keep the $410 cash premium as profit. If gold prices are below 720 at expiration (July 28), the trader could experience a loss.

A more aggressive investor may choose to sell something like a June 825 Gold put for the same premium. He sells closer to the money (closer to the actual price of gold) but he also gets his profit in June instead of August. The caveat being that gold must be above 825 at expiration (May 27).

Figure 1: Aug 08 Gold

There are other aspects to option selling, but this describes the basic concept. Selling options is a high percentage way to profit from a continued bull market while giving one the flexibility to withstand short term moves against ones position. There are many ways to employ different option selling strategies, depending on market conditions. However, in our opinion, selling puts in the gold market is the right strategy at the right time.

We will be working closely with client portfolios in the coming weeks in selling puts underneath the gold and silver markets. Metals appear technically overbought and although selling options is a flexible strategy, waiting for a correction may offer better strikes and/or option premiums for investors.

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
Questions for James and Michael? Visit the Optionetics.com Discussion Board 

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