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The blueprint behind the top-down methodology is quite simple and one that all Optionetics students should incorporate into their trading system. The idea is to identify the strongest trending indexes. This can be either bullish or bearish. Once you have done this, the next step is to find a liquid optionable stock in the particular sector that is highly correlated to that index. In this article I will work demonstrate how this is accomplished.

Identifying the strongest trending sectors may seem tricky at first but can be identified simply by listening to the news, picking up a paper or by reading the daily market commentary. If I were to ask you to think of a strongly trending sector and the direction in which it is traveling, I am sure at least one of the following would come to mind: financials, oil or gold. Whilst financials are a big red bear at the moment, oil and gold are raging bulls. I covered a financial stock in my last article, so for this one I am going to focus on gold.

The bull market in gold was born early 2001 and the only real significant pullback occurred in May/June 2006. Apart from this, it has been a runaway train. The sub-prime turmoil has only fueled the precious yellow metal further. Gold (GC-SpotV in ProfitSource) started taking off in 2001, which was the same time that the US Dollar Index started to fall. This is because gold and the US Dollar Index (DX-SpotV in ProfitSource) are inversely correlated. This means if the US Dollar Index moves down, then gold moves up, and vice versa.

Gold is seen as a safe haven. To briefly explain the economics: when the US economy is not looking so prosperous, interest rate are cut to stimulate the economy. This makes US Dollars less attractive and therefore traders sell it to buy other currencies and gold. As we all know, the Federal Reserve has been cutting rates drastically in an attempt to halt the sub-prime impact. This has been to the detriment of the US Dollar and to the benefit of gold. Coupled with this is the rise in oil prices (CL-SpotV in ProfitSource) along with other commodities (Wheat, Soybeans, Coffee, Sugar etc.), resulting in an increase in the cost of living as price increases are passed on to the consumer. When wages don’t grow at the same pace, it leads to inflation or, even worse, stagflation. Either of these will result in higher prices for gold. Enough of the economics, as the chart tells us everything we need to know. Figure 1 is a weekly overlay of the US Dollar Index, oil and gold. It can be clearly seen the US Dollar Index is inversely correlated to oil and gold.

Figure1: US Dollar Index, Oil and Gold Weekly Line Chart Overlay.
Source: ProfitSource

The US interest rates have several more points to be cut before they hit zero, and it seems the Fed.is ready for further cut—which means the gold rush is not over yet. The best time to enter a trade is during a pullback (sound familiar, Elliott W4 traders?).

Now that a strongly trending sector has been identified it is time to find an optionable stock to trade. Those who own Platinum will find an easy way to do this. Under list tools, click "Correlation Analyzer." This tool provides a list of stocks that move in the same direction as gold. Fill in the template as shown in Figure 2. Notice that I have used the symbol XAU. This is the PHLX Gold/Silver index, which is a close match to the price of gold. The longest correlation period of 249 days is used. The longer the period, the more reliable the output will be. We want stocks with liquid option chains, so I look for a minimum stock volume of 500,000.

Figure 2: Correlation Analyzer
Source: Platinum

The output from the above scan is as follows:

Figure 3: Output from Correlation Analyzer Scan

Notice that GDX has a correlation of 96%, GG 91.9% and so on. The higher ranked symbols are the ones to focus on. The next step is to ensure these are gold companies; then it is time to look for a trade. GDX is an Exchange Traded Fund [ETF], which has interestingly also just broken out of a consolidation triangle. GG is a Canadian gold mining company that has no hedging. This means they do not sell in advance depositories of gold in the ground and hence are able to sell their gold at the prevailing market (spot) price. This is a positive. Both GDX and GG option chains are liquid, so it will come down to which one has the better option trade. Figure 3 shows an OTM (out-of-the-money) butterfly with a maximum risk of $110.

Figure 4: GG 45/50/55 OTM Call Butterfly.
Source: Platinum

Those who do not have Platinum can find correlated stocks to an index on a number of trading websites. Make sure you check that the output companies where you are going to look for a trade are related to the index you searched (gold index = gold companies, oil index = oil companies).

The top-down methodology is great way to ensure that your trades are always going with the flow. This article utilizes the trend in gold. I cannot see any reasons why gold will not push higher for the next couple of years, meaning there will be plenty of opportunities to the upside. For those who wish to trade this long term, I suggest you consider the collar trade or simply buy the stock and use protective puts to lock in profit. Other trending sectors keen readers can investigate include gold’s sister – Silver (SI-SpotV in ProfitSource) and oil.

Make it happen!


Guy Halpin
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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