Strategies to Trade an Overextended Gold Market

The gold market has been getting much attention lately as it is pushing almost daily to new all-time highs, at least in relation to the collapsing US Dollar. There are few voices that suggest this powerful trend could end anytime soon. However, when a trade gets as one sided as is the gold market presently, the time may be ripe for a significant correction. I have been giving warnings of this recently on this blog.

In my previous post I tried to give some insight to the question of whether a downmove would be a temporary pullback with a subsequent return to the primary trend, or if this market is blowing off and the entire uptrend will reverse. There is not a definitive answer to this question yet. I’m sure many analysts will have a correct answer well after the fact, but we have to deal in the real world in real time. Nobody can answer with certainty what any market will do in the next five minutes, let alone the next month or two.

Technical analysis can only go so far in trying to gauge the possibility of a top or bottom of a market. Tops are even more treacherous to try to time in a market such as gold with a high degree of long oriented public participation. If a bubble is forming, that bubble can get larger than anyone thinks is possible. And it can end abruptly and without warning. It can be difficult exiting a profitable long position if the market collapses quickly and blasts through all the stops on a gap. Hedging a long position can be extremely expensive using put options as supply and demand can force up the premiums. Trying to speculate on a trade to capture the potential for a downside break can be even more difficult than simply finding a place to exit a profitable long position. I’ll try to provide some ideas to explore. These ideas are meant for further research and are not intended as trade recommendations.

In designing a trading strategy one has to define what is expected in the market and then deal with a contingency plan in case that expectation is wrong. As I’ve stated many times on this blog, the market can and will do whatever it wants to do. The gold market presently seems to be quite overbought when viewed by sentiment. However, the uptrend seems to be gaining in momentum. In other words, the market can keep going up, which seems to be the path of least resistance, or the market can correct some or all of the previous uptrend since it is so technically overbought and sentiment is so one-sided. Well that’s not too helpful saying the market will go up or down. Trying to determine an answer is to weigh the odds of both scenarios. It is rare that all technical and fundamental factors line up 100% in one direction of the market. If that should occur the market is probably fully priced, with all traders positioned in that direction and a reversal would most likely be at hand. Usually there can be some debate on which direction is the most probable, but it is never certain. One probability that is most likely is that after a near parabolic move in price the parabolic move will either continue or price will blow-off and come back down. From looking at many sharply trending charts over past years it is easy to conclude that odds are lower that a market will have a parabolic move and then just trade in a quiet, extended sideways trend. That can happen, but it seems to be the least likely outcome.

So what strategies could be employed to take advantage of the possibility that the market could make a significant correction, but it might still continue higher, and that it probably won’t start trending sideways, although it could? Before answering that a quick word is in order about some less desirable strategies. If one think a market will come down the easiest and most obvious strategy is simply to short the market. Of course shorting the market can have unlimited upside risk. Nobody knows with certainty when a top is at hand. No technical indicators can time a top with any degree of precision. If the parabolic uptrend continues, a short position could result in tremendous losses. A stop loss can be employed, but if the market starts gapping up, as it has lately in the gold market, the stops would result in losses larger than intended.

Another obvious strategy is simply to by puts. Puts will eliminate the fear of an unlimited loss on the upside since that loss on the trade is limited to what is paid for the put. However, puts can get very expensive when a market heats up. Often times it is very difficult to overcome the cost of the put within the time frame of the put. The market can pull back but maybe not enough to cover the cost of the put or maybe not within the expiration time frame. Longer terms puts can be purchased, but the costs go even higher. But what if the market keeps going higher? A straddle could be purchased, that is buying both the puts and the calls. But this would raise the cost even higher and result in a trade that would be well outside the probability of price movement within the time frame of the options. A very large move on the downside could still be profitable, but any lesser move would most likely result in a large loss, especially on the upside. The other big problem with long option positions is the large amount of time decay, especially as options get closer to expiration.

GLD_backratio

One strategy using option contracts overcoming many of these objections is to do a ratio spread. This spread will make money if the market does move lower as anticipated, but will also make some money if the analysis is completely wrong and the market moves higher. It will lose money if the market stays in the middle. The above chart is an expiration graph of this option spread. The horizontal axis is the prices of the underlying in this case GLD, which is the gold etf that trades with active option contracts. The vertical axis is the dollar profit and loss. The heavier dashed white line is the zero dollar line. The vertical reddish dashed line is the current price of GLD. The green line is the value of the spread at option expiration, which in this case is December 19th. The white line is the value of the spread the next day, in this case November 28th. The white line will increment each day slightly until it coincides with the green expiration line on option expiration day. The screen shots of these graphs were made on November 27th which is a Friday, so the next day is a Saturday with no trading. The option analysis software treats each calendar day the same, but obviously when there is no trading the market makers need to price in time decay during the week. This is an area of discussion beyond the scope of this article. But for the sake of describing these spreads it is accurate enough. Also, these graphs were produced on a shortened holiday session with some unusual news driving the market in thinly traded conditions, so the actual fill prices on these spreads will be somewhat different when normal trading resumes. Again, the graphs are accurate enough to illustrate the concepts.

This trade is constructed by selling 10 GLD December 115 puts, and at the same time buying 20 December 110 puts. The margin required on the trade is a little under $4300. I’m showing a 10 by 20 trade just for illustration. This could be done 1 by 2 or 100 by 200 or any other amount based on what margin is available and what one wants to risk. In this case the entire $4,300 dollars is at risk and that loss would be realized if GLD were to close at the long strike on expiration day, which would be 110 per share on the GLD. As you can see on the white line that there is only a loss at the 110 price as time progresses. If price were to head down to 110 right after trade is put on there would actually be a small profit. If price were to continue to fall the profit potential would be rise continually. The theoretical profits at expiration would be nearly $5,000 at 100, over $15,000 at 90, and over $25,000 at 80. If the analysis was incorrect and the market continues higher there would be a maximum profit of $740 no matter how high the price would go. There is some time decay on this spread, but it is far less than an outright position because the short puts will decay favorably to partially offset the time decay of the long puts. Of course these prices are based on theoretical option pricing at the mid-point between bid and ask, so actual fill prices would be different, and commissions have not been added. This example is just an illustration of a spread that can make money if the market goes up or down, will lose only in the middle as time nears expiration, and has less time decay than an outright long put position. This spread could also be considered using the January options to give it more time to work, although profit and loss parameters will be different. Also, the strike prices can be adjusted to better fit the trader’s expectations and breakeven points.

GLD_broken_wing_butterfly

Another spread worth a look is the broken-wing butterfly, as illustrated above. This spread is again constructed using put option in the December expiration cycle, although January could be used to allow more time to work. This spread will not make money if the uptrend continues, but the amount at risk is strictly limited to the price paid for the spread. In this case the cost and risk a little over $2,000 plus commissions. This is constructed by selling 20 December 105 puts, and then buying wings of 10 each of the December 115 and 100 puts. This spread is unbalanced, hence the name broken wing. The unbalanced nature creates a slightly greater cost and risk, but allows profit potential no matter how low the price goes. Everything in option trading has a trade-off. The trade-off here is that the profit potential is limited if the price goes too far to the downside. In this case the maximum profit potential is almost $8,000 if price were to be at the short strike of 105 at expiration. However, if price overshoots that level and was to be under the long wing of 100 at expiration the profit would be limited to about $2,900, no matter how low price goes. Time decay is minimal because of the 20 short options, and time decay can actually work in favor of the trade as price moves into and under the tent on the graph.

GLD_butterfly

Compare the chart above to the previous chart. The chart above is the regular butterfly. It is constructed in a similar way to the broken wing, however it is symmetrical using wings of 115 and 95 surrounding the 105 short strike rather than being unbalanced. It is a bit cheaper to put on, but the trader has to be careful if price overshoots on the downside as the trade can turn from profit to loss on a very large downward move. The loss is strictly limited to the cost of the trade. This trade is still viable if a trader had a downside bias. The wings can be brought in to substantially lower the cost of the trade. Although it is easier to overshoot on the downside if the width of the breakeven points are closer together, it can still be managed if watched carefully. As with all spreads, there is no requirement to hold these positions until expiration. If a decent percentage gain is available prior to expiration it is easy to simply exit the trade and not risk adverse price movement, especially in the week prior to option expiration. If the trader is very bearish the butterfly can be positioned even further away from the money and the cost of the trade can be very low. The expiration graph can often look too far away to be profitable, but the trade can often be taken off for a profit if the price moves quickly just part way in the desired direction even without reaching the expiration breakeven points. The longer the trade is held the closer it should be to the short strike, so if the move happens early and the trade is profitable it is make to lock in those profits while available.

GLD_calendar

Another trade to consider for a downside break is the calendar spread. The example above is constructed by selling the December 105 puts and then going long the January 105 puts. The theory is that the time decay of the December puts will be faster than that of the January puts. One advantage of this trade is that it has time decay favorable to the trade right from the start. Also, if a market starts to drop quickly volatility can rise. This trade can take advantage of a rising volatility environment, but can be hurt if volatility declines. This trade is much cheaper in margin to put on, and has fewer commissions. The example above costs about $550 for the same 10 lot size, and has a maximum profit of about $2,300 if price is at the strike price of 105 at expiration. The maximum loss is close to the cost of the trade, although changes in volatility can influence that a bit as the actual price of the long January options is not certain. Also, as with the regular butterfly, the downside must be watched because any overshoot in price can turn this back into a losing trade. There are easy adjustments to make if the price begins to overshoot, as this single calendar can easily be turned into a double or triple calendar to extend the range of the expiration breakeven point. Adjustments are beyond the scope of this article.

You might want to refer to the excellent Dan Sheridan webinars on the CBOE website for further information on these and other spreads. If you access through the CBOE you have to create a user name and password to logon to the webcasts. Once that is done click the middle link where it says “Educational Webcasts” and then find the Dan Sheridan group on the left. There are many free presentations. They are each about an hour long. These webcasts are some of the best free educational material available on the internet in my opinion.

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