Gold is still likely to go to $1,000 before it goes to $2,000

Despite all the money pushed into the banking system by the US Federal Reserve and other central banks around the world, there is still no catalyst for gold. Rather than lending the money so that it can turn over in the economy, the bulk of it is being hoarded or put to work in the financial markets. As a result we have inflation showing up in speculative markets such as art and classic cars, but not in the CPI, and until that changes the downside pressure on gold looks set to continue.

With the Fed ramping down its QE programme the next move in the gold price is likely to be down, making another retest of $1,180 highly likely.

The $1,180 level was tested twice in 2014 and in technical analysis it is often said that testing a support level is a bit like jumping on ice, and the more times a price level is tested the more likely it is to be broken. If $1,180 doesn’t hold, then a retest of $1,000, or even a lower support level of around $700, is a very real possibility.

In March 2013 I wrote about a similar setup and outlined a way in which gold investors could profit from a break to the downside. That setup played out perfectly for those that were ready for it, with gold plunging by more than 15% in just a few days.

As the chart below shows, the setup this time is similar, however overhead resistance is actually declining to form what technicians refer to as a descending triangle pattern. This type of pattern is typically considered to be bearish and is formed as the bears gradually gain control and repeatedly push down the price. This selling pressure is countered by the bulls who are able to put a floor under the price, establishing an area of support, but are unable to mount a sustained rally.

An 18 month (daily) chart of gold Click on the chart for a larger version)

An 18 month (daily) chart of gold

Chart courtesy of stockcharts.com

As this type of pattern develops the pressure builds and either the bulls capitulate leading to a downside breakout which confirms the pattern as bearish, or the bulls win the day and the pattern becomes invalid.

Given the bearish fundamentals for the gold market right now a downside breakout seems the most likely outcome and a break of the red support area at around $1,180 is likely to trigger a rapid decline of around $200, or perhaps even more.

As suggested in the previous article, those looking to capitalise on this move could do so via a put option which gives the holder the right (but not the obligation) to assume a short position in the underlying gold futures contract at a specified price (the strike price).

NYMEX gold option prices are quoted in US dollars per ounce, and their underlying futures are traded in lots of 100 troy ounces of gold.

How the trade might work

Given your opinion that gold is likely to decline rapidly from $1,180 to $1,000 if this major support level is violated, you decide to pay a premium of $2,694 (£1,668) to purchase a February 2015 gold put option with a strike price of $1,170. The premium allows you to hold 2 lots which represent 200 troy ounces of gold. You therefore have the right to sell 200 ounces of gold at $1,000, or lower if that level doesn’t hold.

If, prior to the expiration of the contract on 27 January 2015, the price of gold has declined to $1,000 an ounce, you have the option to sell 200 ounces of gold for a gross profit of $34,000 (£21,057), which is the $170 price differential multiplied by the 200 ounces of gold under your control. After subtracting the premium of $2,694 (£1,668) and the $7.47 (£4.62) trading commission, you would have a net profit of $31,298 (£19,384).

Of course if gold does not drop below $1,170 the option would expire worthless and you would have lost the premium and the trading commission.

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