How gold investors can cure their cognitive dissonance

For the past 18 months gold investors have experienced a disturbing phenomenon known as cognitive dissonance. Cognitive dissonance arises when a person tries to hold two conflicting ideas in their brain simultaneously, and it can leave them with feelings of doubt and anxiety.

For gold investors this conflict arises from the fact that the price of gold has been falling since early October 2012, and yet the fundamentals for gold could scarcely be better. We have central banks around the world pursuing open-ended assets purchases, real interest rates in many western countries are still deeply negative, and meaningful economic growth is still proving illusive. In addition both inflation and financial calamity remain a real risk.

The chart below shows the 18 month consolidation in gold. The yellow band represents overhead resistance, while the red band represents major support.

A 2 year (daily) chart of gold (Click on the chart for a larger version)

A 2 year (daily) chart of gold (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

The chart also shows the downtrend channel (blue line) that began in October last year. Although gold has recently climbed back into this channel it remains on a downward trajectory. It therefore continues to be a source of considerable anxiety for investors.

Major support for gold is at around $1,523, however the risk is that this level is violated to the downside. Because $1,523 has acted as a floor under gold for so long, if it were to fail, gold would likely move down very quickly to around $1,400 or perhaps even lower.

While such a drop in price would not necessarily mean that the bull market was over, it would almost certainly mean that many more investors would be feeling even more anxious and would experience even more sleepless nights.

How gold investors can cure their cognitive dissonance

The way gold investors can cure their cognitive dissonance is by taking steps to mitigate the risk of a further decline in the price. There are a number of ways to do this.

For those holding a gold ETF such as GLD, one option for limiting potential downside is to put in place a guaranteed stop loss at around $1,490. There will almost certainly be a cost associated with this type of stop loss, but it will get you out of your position.

It may also be possible to place a spread bet that profits from any decline in gold, however the execution of this is likely to prove very difficult since most providers will not guarantee your order price.

For the more sophisticated investors who are holding physical metal, likely the best way to protect against further declines is via a put option.

Gold options are option contracts in which the underlying asset is a gold futures contract. The holder of a gold put option has the right (but not the obligation) to assume a short position in the underlying gold futures contract at a specified price (the strike price). This right to sell will expire when the market closes on the expiration date.

Gold option contracts are available on both the New York Mercantile Exchange (NYMEX) and the Tokyo Commodity Exchange (TOCOM). 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 will decline sharply from $1,500 to $1,400 if support is violated, you decide to pay a premium of $470 to purchase a May gold put option with a strike price of $1,500. The $470 premium allows you to hold 1 lot which represents 100 troy ounces of gold. You therefore have the right to sell 100 ounces of gold at $1,500.

Assuming that, prior to expiration, the price of the May futures contract has declined to $1,400 an ounce, you have the option to sell 100 ounces of gold at a gross profit of $10,000 ($100 price differential x 100 ounces of gold). After subtracting the premium of $470 and the $7.47 trading commission, you would have a net profit of $9,522.53.

Of course if gold did not drop below $1,500 the option would expire worthless and you would have lost the premium and the trading commission.

It is worth noting that it is also possible to execute a similar trade using FX options by playing the movement of gold versus the US dollar.

Most online brokers only deal with stocks and stock options. However one broker that will let you trade futures and futures options as well as stocks and stock options is Saxo Capital Markets. The firm also has a virtual trading platform where you can practice trading futures and options in real market conditions without the need to risk real money.

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