Not for the Faint of Heart: Short Gold

Looking at the performance of gold over the past couple of months, one can’t help but be amazed by its relentless march higher.  Since bottoming in late July around $1,160/oz., prices have rallied about $200/oz. while putting in a series of new all time highs.  Needless to say, it has been one of the few markets around the world where the bulls have been allowed to run wild.  But how long can this enthusiasm last?

Gold is one of those commodities that can really make an investor look stupid.  Prices often swing dramatically from one day to the next as small shifts in investor sentiment ripple through the market in short order.  And with virtually no way to value gold on a fundamental basis, the ability to gauge when the market is over or under valued is nearly impossible.  As a result, technical analysis, whether chart based or otherwise, is virtually the only tool that can provide us with some sense of where gold is likely to go. 

With that in mind, I decided to look at the current rally in historical context to see if the current streak of higher weekly closes is outside the norm.  Using London Fix price data going back to 2001, gold prices have never finished higher for 10 consecutive weeks.  It is worth noting that this data set comprises the majority of the current decade-long rally which would, in theory, comprise some of the most dramatic rally periods.  The obvious conclusion from this is that gold is ripe for a correction.  Of course, while this run is somewhat unprecedented, there is nothing that says it cannot continue on for some time.  This is where the charts come in.

 As you can see, the Relative Strength Index is indicating that gold is in a fairly significant overbought condition.  As the RSI tends to be more of a short term indicator, this signal would imply a correction is coming rather than an outright reversal of the trend.  The Moving Average Convergence Divergence (MACD) confirms that the intermediate term up trend is still intact.  So taken together, the implication is that the market should correct soon in a sharp, but relatively shallow manner. 

So what does all this mean for investors?  My read is that the gold market is due for some sort of correction very soon that could be worth playing from the short side of the ledger as the risk/reward profile of such a trade appears quite favorable.  While prices could move higher, the overbought condition of the market along with apparent support for the U.S. Dollar (as I outlined in this morning’s post) should help keep a lid on prices over the near term and limit the risk to a short position.   As you can see from the chart, first support (and this is a weak support level) should come in around $1,250 and would represent a $100/oz. drop (-7.4%) from today’s levels.  Should prices break through this level and move towards more significant support around the $1,160 to $1,200 level, returns from 11.0% to 14.1% could be generated from a short position.  These types of returns are certainly nothing to sneeze at.  That said a trade like this is not for the faint of heart and should be undertaken with strict risk controls.  For my part, I would be comfortable with a stop order about 4% above the current price level (approx. price of $1,400), but the appropriate level is different for every investor.

As far as what security to use to perform this type of trade, consider using the Powershares Deutsche Bank Gold Double Short ETN (symbol:  DZZ).  This ETN provides investors with a security that is designed to provide 2 times the opposite return of the daily gold price.  More simply put, if gold falls 1%, DZZ should rise 2%.  Similarly, if gold were to rise 1%, DZZ would be expected to fall by 2%.  This leveraged return structure, however, must be kept in mind when establishing the position to ensure that you do not undertake more risk than you are comfortable with.  As a good rule of thumb, take the percentage of your portfolio that you plan to expose to this trade and purchase half that amount of DZZ.  Since DZZ provides twice the usual return, your effective position (in terms of price movement) will approximate your original position size estimate.  While somewhat thinly traded at 664,334 shares changing hands during an average trading day, this should be enough liquidity for most individual investors.  Also, after doing a little research, I was able to determine that the tracking error associated with this ETN is fairly small, though don’t be surprised to see returns deviated by 1 – 3% over an extended period (a few months).

In closing, I would just say this gold short is one of the more interesting trading opportunities that I’ve seen of late.  I feel like the streak of higher closes truly caps the upside risk for now and signals that a correction is both needed and quickly approaching.  And with so many investors expecting a significant amount of additional monetary stimulus coming from the Federal Reserve, there is a real risk that any announced intervention could fall short of expectations.  This would send the gold market reeling and the U.S. Dollar flying.  On the other hand, it would likely take a sizable increase in monetary stimulus to push the gold market higher and the Dollar lower as so much has already been baked into prices.  In my view, this limits the downside risk of a short gold trade while providing serious profit potential.  Perhaps the release of the FOMC minutes tomorrow afternoon will give the market a sense of what is/is not coming.  Definitely something worth keeping an eye on.

Until tomorrow…..