Gold - What's Next?

Gold sold off in a big way Sunday night (July 20th trading session) following a weak close right on support levels the prior week.

News came out that a big bullion dealer from China sold a very large amount of bullion in a matter of 2 minutes, sending gold prices down to 1080 for a short period of time before bouncing back up.

From what I understand, China holds quite a bit of physical gold and that leaves the door open for additional sales in the future.

Here is the quick headline we got from our partners at TradeTheNews.com:

Gold prices spiked lower during the Asia trading session today, with prices falling almost 4% in a matter of seconds. Reportedly around five tons of bullion, equivalent to one-fifth of a whole day's trade in a normal session, came on the market in China in a two-minute window. One ANZ Bank analyst suggested that the "nature, size and timing of the heavy selling" suggests someone "was taking advantage of low Liquidity Liquidity The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent Read this Term or some sort of forced selling had taken place." Prices probed five-year lows, with spot gold only a few bucks above $1,100 this morning. Dollar weakness isn't helping: after declining to within pips of 1.0820 on Friday, EUR/USD remains not far from four-month lows in the 1.0860 area.

The big question as always in our trading business is "What's next?"

I spent some time both on the daily, weekly and monthly charts looking for some technical clues. It was not easy to find possible targets on the downside as we have not traded in these levels since Feb-March 2010!!

In my opinion, the picture is still quite bearish with lower highs and lower lows both on the daily and weekly chart (weekly Heiken-Ashi chart seen below along with a sell signal my system generated on June 15th):

1065 sticks out as the next possible level in my opinion. I do suspect gold to be volatile, possibly both ways. While the simple way to trade this would be to look for a bounce towards previous support around 1123-1130 and try to go short from that level, another way I currently like is to buy a ratio put spread.

Before I describe the strategy, I must warn you that this specific strategy has unlimited risk as opposed to when one simply buys an outright put. If you don't have much experience with options, I recommend consulting with a broker to see if you are comfortable with the risk.

My trade idea is as follows:

Buy 1 (or quantities in the ratio described below) of the October 1080 puts around $2,000 at the time I am writing this and on the same transaction sell 2 (TWO or similar quantities in the ratio of 1:2) of the 1010 October puts going for around $750 at the time I am writing. This should be executed as a spread. It is a vertical ratio put spread. You pay approx $2,000, you get approx. $1,500 ($750 x 2) so cost before transaction fees is about $500 per spread. Your maximum profit potential per spread is $7,000 if in the optimal scenario the options expire right at 1010.50......

The "funny part" of this strategy, which has a high theoretical chance to succeed, is that if gold breaks lower FAST, the two options which you sold can actually gain against you more than the one you own...

If gold options expire at $950 for example, the option you own will be worth approximately $13,000 and the two that you sold would be worth approximately $6,000 each AGAINST you for a total of $12,000, so you will barely be profitable. The more time left on the options may actually work against you more.

This position will require MARGIN to maintain.

Why I like this strategy? We are using some of the "market's money" to establish a relatively close to the money put position. Rather than pay $2,000 of time value we are reducing our cost quite a bit by selling the two options out of the money. This strategy can either lose a small amount ($500 + fees per spread) if gold drifts higher, can make some money if gold goes lower anywhere between 1080 and $950 depending on time value. Again, the main risk is a very large sell off that will happen fast. At that time you may be actually right on the direction but will find out that this strategy backfired on you.....

Many ways to trade any market, many ways to lose money in any market and only very few ways to lock in gains - this one is not different. If you need help creating a trading plan, visit our broker assist services.

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